What’s it: Deflation is the state of the economy when the aggregate price level falls. This is the opposite of inflation, and we also call it negative inflation.
Deflation is different from disinflation. Disinflation refers to a slower rate of inflation, for example, from 5% to 3%. Meanwhile, deflation means negative inflation, for instance, from 5% to -2%.
Typically, a fall in prices is accompanied by a decrease in the level of employment, output, and trade. Other characteristics are limited credit and the money supply, lower-wage pressure, and lower household or business investment spending.
The purchasing power of money actually increases during deflation. Hence, when prices fall, you can buy more goods and services for the same amount of money.
Even though the purchasing power of money has increased, but, deflation could weaken the economy. This also disadvantages several parties. Since most debt contracts are written for a fixed amount of money, the borrower’s real debt increases during deflation. If you owe the bank, you will have to raise more money to pay the loan installments.
A fall in prices usually occurs during a recession. When prices fall, the profitability outlook falls. Firms that are short of cash will lay off workers and reduce investment because of an increase in the real value of their liabilities and a decrease in profits due to lower prices.
Higher unemployment leads to a decrease in household income, reducing demand for goods and services. The firm then responds by reducing output. As a result, the economy weakens further and can create a dangerous deflationary spiral.
A decline in the aggregate price level can occur due to a fall in aggregate demand, a rise in the aggregate supply, or a reduction in the money supply.
A depreciation in the money supply, for example, occurs when the central bank applies contractionary monetary policy aggressively. Liquidity on financial markets fell, causing credit availability to shrink and interest rates to spike. Such aggressive policy usually occurs when the central bank tries to curb further increases in inflation.
Increase in aggregate supply
As the law of supply says, a higher supply of products and services leads to lower prices. An increase in aggregate supply will lead to an excess supply of goods in the economy. Furthermore, producers will face stiffer competition and will be forced to reduce prices.
Aggregate supply growth can be caused by the following factors:
- Lower production costs
- Technology advances
A reduction in prices for crucial production inputs (e.g., energy prices) will lower production costs. Producers would increase production output, which will lead to excess supply in the economy. While demand remains unchanged, producers need to reduce the prices of goods for people to buy their goods.
Technological advances or applications of new technologies in production can lead to an increase in aggregate supply. Advances in technology will allow producers to lower costs. Thus, the price of the product is likely to fall.
One example is innovation in production technology, such as deflation during the industrial revolution. With the more sophisticated technology, the economic output can increase dramatically, even when using the same input.
The shocks caused by such supply may be less dangerous than those driven by reduced demand. This is because aggregate demand tends to increase along with lower prices, given the unlimited human needs.
A decrease in aggregate demand
A fall in prices due to a decrease in demand can be much more dangerous than an increase in supply. This kind of deflation is more likely to lead to sustained deflation and create a vicious cycle. A decrease in demand can occur due to demand-side shocks, severe economic cycles, or tighter economic policies.
Some of the factors causing a shock in aggregate demand are:
- A decrease in the money supply
- The asset bubble burst
- Recession and worse, depression
- A sharp decline in government spending
- Significant increase in tax rates
Central banks might adopt a tighter monetary policy by raising interest rates. Thus, people, instead of spending their money right away, would rather save it. Also, an increase in interest rates will lead to higher borrowing costs, which will also hinder spending.
A demand shock can also occur after an asset bubble or a commodity shock. In this situation, the prices of assets (such as stocks and housing) and commodities (such as oil) skyrocket.
The bubble will eventually burst, leading to lower prices. Lower prices hurt inflation expectations in the economy and can lead to a deflationary process.
A continued severe contraction in the economy can lead to a deep recession, in which general prices fall. For example, during a recession, people can become more pessimistic about the future of the economy. Furthermore, they will prefer to increase their savings and reduce current spending.
Likewise, a decrease in government spending or a significant increase in the tax rate can also reduce aggregate demand. As a result, the aggregate price level falls.
In theory, deflationary pressures are possible to occur when the economy operates below its potential output. In this case, the output gap (the difference between actual real GDP and potential GDP) is negative. We call this situation the deflationary gap.
Why do I say possibility? The deflationary gap does not always lead to deflation. At that point, the percentage increase in aggregate prices may slow down and cause disinflation rather than deflation.
Unlike disinflation, deflation is dangerous for the economy. For businesses, falling prices weaken the face value of sales and squeeze profit margins. This forces them to rationalize operating costs and cut production. Much of the productive capacity of the company is underutilized so that many workers are unemployed.
As a result, unemployment has increased, and the income outlook weakens. This situation decreases the ability of households to pay debts or consume.
Simultaneously, the real costs of pensions and wages fall on firms unless they can cut them. Companies that are short of cash will cut off workers and reduce investment.
Because most debt contracts are written in a fixed monetary amount, the real value of the debt increases (known as debt deflation). Also, those with high leverage can face bankruptcy and sometimes lead to bank failures. The increased risk of default forces banks to reduce lending, and companies find it challenging to get new financing.
If the general decline in prices persists, the economy could enter a deflationary spiral. If that happens, it can deepen deflation, which is very difficult to reverse.
How did the deflationary spiral come about?
Lower prices during deflation force firms to cut output and production costs, particularly labor costs. This leads to lower wages and household income.
Households have less money to spend on goods and services. Simultaneously, when prices fall, households postpone purchases hoping that the price of the goods will be lower in the future—consequently, the current demand for goods and services decreases.
Lower demand leads to further price reductions. This leads to lower levels of production, which in turn lowers wages and further depresses demand. This situation continues and creates a downward spiral in prices in the economy (deflationary spiral).
Possible solutions to tackle deflation
Low inflation is usually preferable over deflation. For some developed countries, the ideal inflation is around 2%.
The government tries to avoid deflation. Like high inflation, too-deep deflation can destabilize the economy.
The government will usually launch a loose economic policy (expansionary economic policy) to get out of deflation. From the fiscal side, governments can lower tax rates or increase their spending.
On the monetary side, the central bank can choose options: cut interest rates, lower the reserve requirement ratio, or buy government securities through open market operations. That is all to increase the money supply circulating in the economy.
The expansionary economic policy seeks to push up prices through its effect on aggregate demand. An increase in demand will push prices up.
Say, the central bank cuts interest rates to stimulate demand for goods and services. Lower interest rates mean cheaper new borrowings. This encourages households to apply for new loans to finance several products, especially durable goods.
As demand increased, producers responded by intensifying their production facilities. If demand gets more robust, they increase output by buying capital goods, developing new facilities, and recruiting new workers.