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April 7, 2012

Is Deflation Bad??


In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the annual inflation rate falls below 0% (a negative inflation rate). This should not be confused with disinflation, a slow-down in the inflation rate (i.e. when inflation declines to lower levels). Inflation reduces the real value of money over time; conversely, deflation increases the real value of money – the currency of a national or regional economy. This allows one to buy more goods with the same amount of money over time. Economists generally believe that deflation is a problem in a modern economy because of the danger of a deflationary spiral. Deflation is correlated with recessions including the Great Depression, as banks defaulted on depositors. We have explained in this paper the causes, effects and various historical examples of deflation around the world

Causes of Deflation

· Capitalism characterized by sufficient existence of competition, is regarded as one of the factors responsible for the emergence of Deflation. In this case, with the improvement in the capital stocks, competition increases million fold. Escalation in the total number of competitors boosts up the supply of goods, indicating that the prices must decrease in order to stabilize the demand, thereby bringing in Deflation. Capitalism also brings in innovation and efficiency, which also contributes towards the initiation of Deflation.

· In an economy based on credit, a decrease in money supply results in remarkably less lending trend, followed by a sharp decline in the money supply. As a result, there occurs a sharp reduction in the demand for goods. A decline in the demand is followed by a decline in the prices, owing to the development of a condition called the supply glut. Gradually, this assumes the form of a deflationary spiral, where the prices go down below the costs of financing production.

· With the advent of deflationary spiral in an economy, the commercial sector of the country stops incurring profits, despite lowering the prices of their finished products. Ultimately, a situation arises where this commercial sector is forced to become liquidated. In order to prevent or slacken down the deflationary spiral, it is necessary for the banks to avoid the collection of non-performing loans.

· According to the monetarist viewpoint, Deflation occurs when there is a decrease in the velocity of money, and/or in the amount of monetary supply per person. Deflation helps the economy grow and develop at a rapid pace, even faster than the creation of hard money.

Following would be a simple illustration explaining the causes of deflation in four forms. Let's assume that we are on an island and there are ten equally desirable goods in our universe and ten $1.00 bills available to purchase them with. We can safely assume that each item will end up costing $1.00 each.

If the quantity of money increases to $20 (without increasing the quantity of goods) the price of the goods will increase to $2.00 - that is inflation.

If, however, the quantity of money decreases to $5.00 the price will fall to 50¢ (deflation). This is what the first part of the above definition is referring to. The money supply can also be reduced if someone on our island hoards half of it and refuses to spend it on anything no matter what. This is the second part of the definition (reduction in spending). So far we have only looked at part of the equation, the supply of money. But what happens if the quantity of goods available increases? What if instead of having ten items we build ten more? We now have twenty items and only $10. 00 so once again each item is worth 50¢. This form of deflation is the good type. Everyone assumes that deflation is bad because the last major deflation that we had was during the "Great Depression" so deflation and Depression are synonymous in many peoples minds. In actuality if prices go down because the goods can be manufactured more cheaply this ends up increasing everyone's wealth. This is exactly what happened in the late 1990s , with cheap productivity available from former Communist countries the quantity of goods is increased while the money supply increased at a slower rate.

What about the demand for goods? If everyone on our island already has one of the items available and no one needs any more, naturally the price will also fall as sellers try to find someone to take them off their hands. So far we have dealt with the supply of money, the supply of goods and the demand for goods, but what about the demand for money?

Is it possible that the demand for money could increase or decrease? Generally, the demand for money is measured by how much people are willing to pay to borrow it (i.e. interest rates). If inflation is high, interest rates will have to be higher to compensate for the loss of purchasing power. But also if the demand for money rises banks can charge more to loan it. Conversely, if the demand for money falls interest rates will also fall.

So there are four causes for Deflation.

  1. Decreasing Money Supply
  2. Increasing Supply of Goods
  3. Decreasing Demand for Goods
  4. Increasing Demand for Money

Effects of deflation

Deflation is an economic theory, which deals with the general reduction in the price levels or in the prices of a type of good or asset. The effects of Deflation are immense on the economic conditions of a particular nation. With respect to the effects of Deflation, one should not mix up the concept with that of a temporary decrease in the prices. Deflation affects the general price fall in a sustained manner, exerting more or less permanent influence on a country's economy. Following are the diverse ways in which Deflation impacts the economic condition of a country:

· Deflation results in the improvement of production efficiency, due to lowering of the overall price of commodities. The production efficiency of a country develops at a time when the economic producers of goods and services are propelled sufficiently by a promise of enhancing their profit margins, by improving the overall standard of their products. At this point, the consumers are required to make low payment while buying those goods. This increases the purchasing power, and culminates into an economic condition called Deflation.

· Deflation is considered to be a natural phenomenon, as far as hard currency economies are concerned. In this case, the rate of increase in money supply is not maintained in proportion to the positive population and the general growth of the economy. Under such circumstance, the per-head availability of hard money reduces. This leads to the escalation in the purchasing power of each unit of currency. This permanent deflationary condition is visible in the later part of the 19th century, with noticeable developments in the economy under the above-mentioned conditions. Hard money economies claim that the economy involves no rigidity. Hence Deflation is a most welcome phenomenon here, for the economy to make diversified ventures in other fields as well, owing to the lowering of prices. This is always a good deflationary effect, as far as economic growth and development is concerned.

· Deflation generally exerts negative impact on a country's economic conditions. This is because the advent of Deflation acts as a tax on the borrowers and the liquid asset holders simultaneously. This in turn, acts as a benefit, as far as the liquid cash and asset holders and the savers are concerned. Thus, Deflation is just the opposite economic situation to Inflation, levying tax on money lenders and holders, in the interest of short-term consumption and that of the borrowers. As per the contemporary economic thoughts, the concept of Deflation is associated with a certain amount of risk. Here, the risk-adjusted return of assets becomes negative in nature, thereby encouraging the purchasers and investors to gather money, rather than investing it in solid and assured securities. This leads to the formation of a theoretical condition known as Liquidity Trap. Liquidity trap is regarded as a critical condition as it stagnates the economy, where the nominal rate of interest becomes zero or close to zero.

· Deflation discourages both investment and expenditure. In contemporary economic conditions, the penalties associated with Deflation have increased. This escalation results from lengthy loan terms , essential for the continuation of general commercial activities and building of a country. In fact, Deflation brings with it, a fall in the aggregate demand. Emergence of deflationary spiral is considered to be one of the primary impacts of Deflation. In this case, there is fall in the prices, resulting in the creation of a vicious circle. This makes a problematic situation to worsen, rather than reaching any amicable solution. Perhaps, the greatest instance of deflationary spiral is the Great Depression, occurring in the United States of America during the Civil War.

· According to the Monetarist Theory of Deflation, Deflation affects an economy by decreasing the velocity of money or the number of commercial transactions more or less permanently. This leads to the emergence of a remarkable contraction in the supply of money.

Inflation vs Deflation

Inflation is the opposite of deflation and refers to a rise in the general level of the prices of goods and services. Deflation is considered as negative inflation because it increases the real value in money, whereas inflation has the reverse effect. Deflation causes a burden on borrowers and holders of various illiquid assets and is favorable for savers and holders of liquid assets and currency. On the other hand, inflation favors short-term consumption and borrowers and is a burden on currency holders and savers. Both inflation and deflation can negatively impact the economy. However, most economists consider the effects of moderate long-term inflation to be less damaging than deflation

Types of deflation

Actually, deflation itself is neither good nor bad. It depends on the cause of the deflation whether people will suffer or rejoice. Based on this deflation is classified into Good Deflation and Bad deflation

Good Deflation

Good Deflation should not be considered as a hypothetical situation. It is very much a real condition of the economy, characterized by substantial growth and development in some sectors of a country, despite the fact that the prices of products in these sectors has been reducing since a long span of time. In fact, Good Deflation results from technological progresses, which initiates excess supply of goods.

· From the consumer's point of view, Good Deflation is immensely beneficial as it helps those commercial sectors like the bank to deal with sinking prices. The banking sector of a country faces such as a situation, when the value of the collateral (securities) for loans decreases remarkably, having low sale value than what was earlier expected. This condition is far more aggravated by public debts and unemployment problem, which display rising trends. This situation is controlled to considerable extents by the advent of Good Deflation. In the theoretical sense, Good Deflation does not allow the distribution of corporate gains among the employees, in the form of increase in their wages. Instead, decrease in the prices owing to Deflation is transferred to the consumers. This leads to uniform allocation of the profits, involving those also, who are not directly associated with production.

· The debtors should evade price fall, which appears to them in the form of low rates of interest.

· Good Deflation can only work when people have full faith in the future of the concept, which is closely related with the consumption and investments on their part. In fact, the customers consume and invest to meet their requirements and not the price expectations.

· For Good Deflation to exist in an economy, it is required that there is no interference of any strong union, who may insist on productivity gain on behalf of the employees.

Bad Deflation

Bad Deflation is born out of trifling demands. It is an economic situation characterized by reduction in the prices not due to developments in the productivities, but because of a lack of demand induced by crashing down of the stock market. In fact, Deflation becomes bad when the consumers save their money for future uncertainties, or in the expectation that prices may lower further.

· It is the cumulative process of very little generation of demand which affects the population of a country at the time of Bad Deflation. Detection of Bad Deflation thus requires an in-depth study of the overall economic conditions of a nation and not just the price of goods.

· Owing to Bad Deflation, the consumers who are the potential purchasers become unwilling to invest and buy, considering the future of their money and the country's economy. This leads to a fast fall in the prices, worsening the overall economic conditions further. Under the impact of Bad Deflation, the recessions are virtually all transformed into depressions. In reality, it is not the price fall of Bad Inflation which matters, but the serious consequences it gives birth to.

Measures to correct deflation

Quantitative Instruments

1) Changes in Bank Rate Policy or Rediscount Rate:

To remove deflation central bank will decrease the bank rate, the commercial banks will also decrease the rate loans. In this way, people will get more loans. Investment production, employment and Prices will start rising up. Accordingly, deflation will be controlled.

2) Open Market Operation

This is the second instrument of the monetary policy. If there is deflation in the economy, to control deflation, the central bank purchases the government securities. Then the monetary base of the commercial banks will increase their loaning power will increase. As a result, investment will increase, income and prices will go up.

3) Changes in Reserve Requirements

In case of deflation, the central bank reduces the reserve requirements, the commercial banks will be able to advance' more loans. Hence, deflation could be removed.

4) Changes in Reserve Capital

Each commercial bank has to keep a certain ratio of its deposit with central bank. In case of Pakistan, each commercial bank has to keep 5% of its deposit in the central bank. By changing the reserve capital, a central bank can control the supply of money by commercial banks. On the other hand, if central bank decreases the 'reserve ratio, the commercial banks will be having more funds to advance. Accordingly, the deflation could be controlled.

5) Changes in Marginal Requirements

Commercial banks do not give loans against leaves, rather they ask for pledges to make. How much a person will have to pledge is settled by the central bank. This is given the name of marginal requirement. The central bank can bring changes in the marginal requirements. During deflation the marginal requirements are decreased. Hence people will get more loans from the commercial banks. As a result supply of money will go up and deflation will be controlled.

Qualitative Methods

1) Moral Suasion: It is concerned with just as a moral request by central bank to commercial banks to provide more loans at cheaper rate to control deflation.

2) Publicity: The central bank of the country is the overall in charge of economic stability of the country. Its aim is to protect the economy from inflation and deflation. For this purpose, it analyses the whole economy. It keeps an eye over the activities of the commercial banks. If the commercial banks are found advancing loans which create inflation or deflation, their activities will be unhealthy for whole economy. The central bank can black list such banks. Thus to avoid such bad reputation in' future, they will be careful in advancing loans.

Historic examples of deflation around the world

In Hong Kong

Following the Asian financial crisis in late 1997, Hong Kong experienced a long period of deflation which did not end until the 4th quarter of 2004. Many East Asian currencies devalued following the crisis. The Hong Kong dollar however, was pegged to the US Dollar, leading to an adjustment instead by a deflation of consumer prices. The situation was worsened by the increasingly cheap exports from Mainland China, and weak consumer confidence in Hong Kong. This deflation was accompanied by an economic slump that was more severe and prolonged than those of the surrounding countries that devalued their currencies in the wake of the Asian financial crisis.

In Ireland

In February 2009, Ireland's Central Statistics Office announced that during January 2009, the country experienced deflation, with prices falling by 0.1% from the same time in 2008. This is the first time deflation has hit the Irish economy since 1960. Overall consumer prices decreased by 1.7% in the month.

Brian Lenihan, Ireland's Minister for Finance, mentioned deflation in an interview with RTÉ Radio. According to RTÉ's account, "Minister for Finance Brian Lenihan has said that deflation must be taken into account when Budget cuts in child benefit, public sector pay and professional fees are being considered. Mr Lenihan said month-on-month there has been a 6.6% decline in the cost of living this year."

This interview is notable in that the deflation referred to is not discernibly regarded negatively by the Minister in the interview. The Minister mentions the deflation as an item of data helpful to the arguments for a cut in certain benefits. The alleged economic harm caused by deflation is not alluded to or mentioned by this member of government. This is a notable example of deflation in the modern era being discussed by a senior financial Minister without any mention of how it might be avoided, or whether it should be.

In Japan

Deflation started in the early 1990s. The Bank of Japan and the government tried to eliminate it by reducing interest rates (part of their 'quantitative easing' policy), but this was unsuccessful for over a decade. In July 2006, the zero-rate policy was ended.

Systemic reasons for deflation in Japan can be said to include:

§ Unfavorable demographics. Japan has an aging population (22.6% over age 65) that is not growing and will soon start a long decline. The Japanese death rate recently exceeded the birth rate.

§ Fallen asset prices. In the case of Japan asset price deflation was a mean reversion or correction back to the price level that prevailed before the asset bubble. There was a rather large price bubble in equities and especially real estate in Japan in the 1980s (peaking in late 1989).

§ Insolvent companies: Banks lent to companies and individuals that invested in real estate. When real estate values dropped, these loans could not be paid. The banks could try to collect on the collateral (land), but this wouldn't pay off the loan. Banks delayed that decision, hoping asset prices would improve. These delays were allowed by national banking regulators. Some banks made even more loans to these companies that are used to service the debt they already had. This continuing process is known as maintaining an "unrealized loss", and until the assets are completely revalued and/or sold off (and the loss realized), it will continue to be a deflationary force in the economy. Improving bankruptcy law, land transfer law, and tax law have been suggested (by The Economist) as methods to speed this process and thus end the deflation.

§ Insolvent banks: Banks with a larger percentage of their loans which are "non-performing", that is to say, they are not receiving payments on them, but have not yet written them off, cannot lend more money; they must increase their cash reserves to cover the bad loans.

§ Fear of insolvent banks: Japanese people are afraid that banks will collapse so they prefer to buy (United States or Japanese) Treasury bonds instead of saving their money in a bank account. This likewise means the money is not available for lending and therefore economic growth. This means that the savings rate depresses consumption, but does not appear in the economy in an efficient form to spur new investment. People also save by owning real estate, further slowing growth, since it inflates land prices.

§ Imported deflation: Japan imports Chinese and other countries' inexpensive consumable goods (due to lower wages and fast growth in those countries) and inexpensive raw materials, many of which reached all time real price minimums in the early 2000s. Thus, prices of imported products are decreasing. Domestic producers must match these prices in order to remain competitive. This decreases prices for many things in the economy, and thus is deflationary.

In November 2009 Japan has returned to deflation, according to the Wall Street Journal. Bloomberg L.P. reports that consumer prices fell in October 2009 by a near record 2.2%

In the United States

There have been three significant periods of deflation in the United States.

The first was the recession of the late 1830s, following the Panic of 1837, when the currency in the United States contracted by about 30%, a contraction which is only matched by the Great Depression. This "deflation" satisfies both definitions, that of a decrease in prices and a decrease in the available quantity of money.

The second was after the Civil War, sometimes called The Great Deflation. It was possibly spurred by return to a gold standard, retiring paper money printed during the Civil War.

"The Great Sag of 1873-96 could be near the top of the list. Its scope was global. It featured cost-cutting and productivity-enhancing technologies. It flummoxed the experts with its persistence, and it resisted attempts by politicians to understand it, let alone reverse it. It delivered a generation’s worth of rising bond prices, as well as the usual losses to unwary creditors via defaults and early calls. Between 1875 and 1896, according to Milton Friedman,prices fell in the United States by 1.7% a year, and in Britain by 0.8% a year.

The third was between 1930–1933 when the rate of deflation was approximately 10 percent/year, part of the United States' slide into the Great Depression, where banks failed and unemployment peaked at 25%.

The deflation of the Great Depression, as in 1836, did not begin because of any sudden rise or surplus in output. It occurred because there was an enormous contraction of credit (money), bankruptcies creating an environment where cash was in frantic demand, and the Federal Reserve did not adequately accommodate that demand, so banks toppled one-by-one (because they were unable to meet the sudden demand for cash— see Fractional-reserve banking). From the standpoint of the Fisher equation (see above), there was a concomitant drop both in money supply (credit) and the velocity of money which was so profound that price deflation took hold despite the increases in money supply spurred by the Federal Reserve.

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