Most people have heard of the word ‘inflation’ and are aware of how it works or what its implications are. However, not as many people are aware of deflation and how it can affect them. The common misconception is that deflation, meaning a considerable drop in prices across the economy, is a good thing. But the reality is actually the opposite. In order to understand the difference between inflation and deflation, read on to learn more about deflation and its features:
What Is Deflation?
Deflation is essentially a notable decline in prices across the general economy. It is associated with a contraction in credit and money supply in the economy. As a result, the currency purchasing power steadily goes up. Other reasons for deflation can also be a general increase in productivity or technological advancements.
Due to deflation, the associated nominal costs for labour, capital, goods and services see a drop, even if the relative prices do not see a big change. At face value, consumers may find deflation beneficial because the same nominal income now has more purchasing power. However, a consequence of deflation on various sectors can lead to an adverse effect on borrowers who have to return more money with a greater value than the initial borrowing. It also impacts investment prospects in the financial market.
What Are The Causes Of Deflation?
A decrease in money supply, credit and financial instruments in the market is the primary reason for monetary deflation.
When money and credit supply drops and economic output cannot keep up, prices all over the market fall.
Extended durations of artificial monetary expansion are commonly followed by deflation.
Large scale events such as financial institution/ bank failures can lead to deflation.
A decrease in aggregate demand for goods and services can also lead to a decrease in prices. This can happen to cutdowns on government expenditure, higher consumer savings, failures in the stock market or stricter monetary policies.
A decrease in prices can also happen organically if the economic output exceeds the existing money supply in the economy. This tends to happen as a result of important technological advancements. Lower production energy and cost add to savings and reduce market prices.
What Are The Consequences Of Deflation?
Unemployment can be a very adverse consequence of deflation; if company profits are reducing due to price drops, companies may start laying off employees.
Interest rates can shoot up during deflation, making debt investment costs go up too.
The domino effect due to the chain reaction between economic components, also known as the deflationary Sprial can have a negative impact
Production may fall as a result of the drop in prices, leading to lower wages, thereby reducing demand. This will further reduce prices, and worsen the economic condition further.
How Can Deflation Be Controlled?
Governments can utilize certain strategies to control deflation:
Increasing money supply in the economy with the assistance of the central financial institution
Easing the borrowing process by boosting the credit supply or bringing down interest rates. This will encourage borrowing, spending and therefore raises prices.
Managing policies by boosting public expenditure and reducing taxation, to increase demand as well as disposable income to increase spending.
Why Does Deflation Matter?
While deflation is the opposite of inflation, the impact can be just as serious. Since deflation, much like inflation, can turn into a vicious cycle the whole economy can suffer. When prices in the economy continue to see a decrease, consumers’ spending is withheld while they wait for prices to reach an optimal number. So demand continues to decrease, contributing to deflation further. The whole economy may see a standstill and put innovation and overall growth on hold.
Types Of Deflation
Two main types of deflation are ‘good deflation’ and ‘bad deflation’
- Good Deflation:
Deflation due to lower costs is called good deflation. A rapid increase in productivity can lead to lower prices without reducing the supply of goods and services and opening up the potential for great profits. In theory, this can then help in increasing wages. A bigger disposable income will also contribute to more spending, keeping the cycle going.
- Bad Deflation
Bad deflation is that which is caused due to a reduction in demand. Low demand leads to dropping prices, causing loss instead of profit. Thus wages will be reduced and employees laid off. Hence, spending will decrease as will consumption. While waiting for prices to fall low enough for the goods to be affordable, the economy will see a massive slowdown.
India is familiar with inflation and has also undergone periods of deflation. This phenomenon can impact the government, consumers and businesses in different capacities. It can also make debt financing an unviable option. However, it can benefit savings-based equities. For investors, businesses that have little debt or hold large reserves of cash offer more lucrative investment options. Deflation may also increase the risk premium for securities and yields that are rising.
Proportionate deflation can be very beneficial for the economic growth of a country, not to mention it has the potential to improve the average consumer’s standard of living. In excess, it can drastically reduce spending capacity and worsen economic crises in the country. Hence, the government does its best to establish measures that can help combat such adversities and minimize the impact while still keeping the country’s economic interest in mind.