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Deflation

Deflation Definition

According to economy, deflation is a continued decrease in the general price level of goods and services in an economy. In other words, a general dwindling in prices, usually caused by a decrease in the supply of money or credit. This is to say that an economy becomes deflated when the inflation rate decreases to below the zero percent mark, hence resulting in an increase in real money value. Whereas inflation enhances the real value of money, deflation on the other hand increases the real value of money over a period of time.

Causes of deflation

One main cause of deflation in an economy is how the supply and demand of goods and services combines with the supply and demand for money. More particularly when the supply of money decreases and the good’s supply escalate. A monetarist sees the primary cause of deflation is the decrease in the supply of money per individual and/or the velocity of money.

Today’s credit-based economists believe that the vicious deflationary spirals can be caused by the Federal Reserves (in this case the central banks of countries), as they impose high interest rates, with an aim to counter inflation. As a result, the economy may collapse or it may cause asset deflation, which has been kept at a high production level than it could essentially support. By the same token, investment, government or personal spending is also believed to cause deflation.

Increase in the purchasing power likewise causes deflation. In a typical business setting, producers of goods and services lower the overall price of their products to improve production competence. This is motivated by the hope that the improvements will increase profit. In a competitive market, the producers thus are prompted to reduce the asking price to save costs. As a result, the consumers pay a lower price for the goods or services, and consequently, deflation has basically occurred because of the increased purchasing power.

Effects of Deflation

The immediate notable effects of the persistence decline of prices on goods and services is the vicious spiral of negatives like factories closing down, shrinking incomes and employments, dwindling profits and increasing defaults on loans by individuals and companies. As a counter measure of these negatives, the Federal Reserve imposes a financial policy to increase the supply of money and intentionally induce escalating prices, hence causing inflation.

Deflation causes a drop on the collective level of demand meaning that in an economy, there is a general fall on how much the whole economy is willing to buy goods, and the price at which they are willing to buy at. This is because, since the price of goods is falling, buyers would be tempted to delay purchasing and consuming products, till the prices drop further, resulting in a reduced economic activity hence adding up to the deflationary spiral.

Deflation increases the sales and the economic activities in a nation by making basics such as food, fuel and housing, more affordable to poor citizens, thus reducing severity and the length of recession. On the same point, most people regard deflation negatively since it causes a shift of wealth from individuals who borrow and hold illiquid assets, to individuals who save and hold liquid assets and currencies.

By and large, modern day economists all agree that the effects of an extended inflation are by far less destructive than deflation, which is more difficult to control as it raises real earnings, thus making it very costly and difficult to manage to lower sustainable levels. However, central banks endeavor to stop severe deflation by maintaining extreme drops in prices to the minimum. Relatively, the deflationary periods can be either short or long.

Tags: bank, credit, government, Income, interest rates, loan, market, money, policy, price

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