Why is Deflation bad for the economy?

A decrease in prices within an economy and an increase of the buying power of the currency is called deflation. This can be caused by an increase or decrease in productivity or the availability of goods or services, as well as a decrease or aggregate demand.

 

KEY TAKEAWAYS

  • Inflation occurs when prices fall in a country, as opposed to rising inflation.
  • An increase in productivity, decrease in overall demand or a decrease of the credit available in the economy can all lead to deflation.
  • Deflation is usually a positive trend in the economy. However, it can sometimes occur alongside a contraction.
  • Deflation is a temporary financial crisis that can occur in an economy where debt-fueled asset bubbles dominate.

Understanding Deflation

Economic statistics are used to track changes in consumer prices. They compare the changes in a basket containing diverse goods and products with an index. The Consumer Price Index is the most widely used index to evaluate inflation rates in the United States. If the index is lower in one period than the previous, it means that prices are falling.

 

A general drop in prices is good because it increases consumers’ purchasing power. Moderate drops in prices for certain products like food and energy can have a positive impact on consumer spending. A general and persistent drop in all prices can allow people to consume more and promote economic growth. It also enhances the value of money and encourages real savings.

 

In certain cases, however, rapid deflation may be associated with a temporary contraction in economic activity. This can happen when an economy is heavily indebted and dependent on continuous credit expansion to inflate asset values by financing speculative investments. Asset prices then fall and speculative overinvestments are liquidated.

Sometimes, this process is called debt deflation. Deflation, on the other hand, is a normal feature of a healthy, expanding economy that reflects technological advancement, increased abundance, and higher standards of living.

 

Deflation: Causes & Effects

According to the popular saying, inflation is caused by too much money trying to chase not enough goods in an economy. Conversely, deflation can be described as a growing supply or slow-growing money that chases down goods and services.

 

Deflation can either be caused by an increase or decrease in the supply goods and services, or by a lack thereof. If prices are able to adjust downward, this will result in a generally falling level of price.

 

Technology progress, discovery of new resources or an increase of productivity are all factors that lead to an increase in the supply of goods, services, and services in an economy.

 

As their wages and business incomes increase, so does their purchasing power. This allows them to buy, use and consume higher quality goods and services. This is a positive trend for society and the economy.

 

The U.S. government aims to achieve an annual inflation rate below 2%.

Some economists fear that falling prices will paradoxically decrease consumption, inducing consumers not to buy or to delay purchases to pay higher prices in the future. However, this is unlikely to happen during normal periods of economic growth with falling prices due to technological improvements, productivity, or resource availability.

 

Furthermore, most of the consumption is comprised of goods and services that cannot be deferred to future, even if consumers want to. These include food, clothing, transport, healthcare, and housing services.

 

These basic needs aside, consumers will only reduce their current spending if the rate of price declines exceeds their natural preference for future consumption.

 

Falling prices will only affect consumer spending on items that are regularly financed with large debts, as the real value of fixed debt will rise over time.

 

Debt, speculation, and debt Deflation

Deflation can occur during and after economic crises, but only under certain conditions.

 

A highly financially oriented economy where a central banking or another monetary authority, or the bank system generally, engages in continuous expansion of the money supply in the economy, the reliance upon newly created credit to finance consumer spending, business operations, financial speculation and commodity prices leads to ongoing inflation in rents, wages and asset prices.

 

Increasingly, investment activity is based on speculation about the price appreciation of financial assets and other assets rather than profit or dividend payments on fundamentally sound economic activity.

 

Businesses are also more dependent on the availability and turnover of credit than on real savings to finance their operations. In addition to borrowing heavily, consumers are more inclined to finance their spending with ongoing savings rather than by borrowing heavily.

 

Although gold is often considered a good hedge against inflation, it can also be used to hedge against deflation.

This inflationary process often involves the suppression market interest rates. This distorts business investment decisions, as well as how they are funded. At the first sign that there is trouble, conditions are ripe to allow debt deflation.

 

A real economic shock, or a correction of market interest rates, can cause financial pressure to heavily indebted consumers and businesses. Many of these people have difficulty refinancing or revolving their debt obligations, such as student loans, mortgages and business loans.

 

These delinquencies, along with defaults, lead to debt liquidation and write-downs bad loans by lenders. This can cause a reduction in credit supply to the economy.

 

In the event of bank failure, banks’ balance sheets may become more unstable. Depositors might seek out cash to cover their losses. An bank ran could occur when banks take on more loans than they can afford and have insufficient cash reserves. The bank is unable to meet its obligations. Financial institutions can collapse by removing liquidity which borrowers are more indebted.

 

The reduction in money supply and credit means that consumers, businesses and speculative investors are less able to borrow more and to bid up commodity and consumer goods prices. Prices may then stop rising or fall.

 

Falling prices place even greater pressure on consumers, investors, indebted companies, and consumers because their nominal debts remain fixed as their revenues, incomes and collateral fall through price deflation. At that point, the cycle between debt and price inflation feeds itself.

 

This process of debt deflation can lead to a wave in business failures and personal bankruptcies as well as increasing unemployment. As debt-financed consumption and investment fall, the economy experiences recession. Economic output is affected by this.

 

What is Deflation in an Economic Economy?

When the prices of goods or services fall across the economy, it is called deflation. This increases the purchasing power of consumers. This is the opposite of inflation, and it can be a problem for a country as it can signal an economic downturn that could lead to a recession. Positive factors such as technological advancements can also cause deflation.

 

Is Deflation worse than Inflation?

It depends. It all depends. Positive factors such as technological improvements that lower the cost of goods or services can make deflation more bearable than inflation.

 

How can you make money in a time of deflation?

Investors can buy investment-grade bonds, consumer stocks, dividend stocks to hedge against inflation. They also have the option of keeping their cash in cash. Diversified portfolios can help protect against many economic situations.

 

The bottom line

A little deflation can be a result of economic growth and is good for it. However, if a central bank-fueled debt bubble is created across the economy, and then the debt bubble bursts, rapid falling prices can be accompanied by a financial crisis or recession.

 

The recession and period of debt deflation that follows are temporary, and can be avoided if you resist the temptation to increase the money supply and credit.

 

It is not the deflation of a country’s economy, but its inflationary period which then leads to deflation. Unfortunately, this has been the norm for the past century.

 

This means that even if these policies continue, deflation will continue being associated with the economic damage they have caused.

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