What Is Deflation?
Discussions about monetary policy in the general public and mainstream media tend to focus primarily on the more-popular concept of inflation.
A quick refresher: Inflation is the increase of an average price of a specific basket of goods in an economy during a specific period of time. Due to a rise in the price of the goods, a unit of currency buys fewer units of the goods than the currency did prior to the increase in price. Therefore, the currency loses its purchasing power.
Deflation is the opposite of inflation.
Deflation is a decrease in the price of goods in an economy during a specific period of time. Due to a decrease in the price of the goods, a unit of currency buys more units of the goods than the currency did prior to the decrease in price. Therefore, the currency increases in its purchasing power.
While inflation is generally caused by an increase in the money supply in an economy, deflation is generally caused by a decrease in the money supply in an economy.
Money Supply and Deflation
Like inflation, deflation is inextricably linked to the supply of money in an economy.
Deflation is generally caused by a decrease in the supply of money in the economy.
The supply of money is the responsibility of the central bank of a country. Most central banks set and implement monetary policy to manage the supply of money in order to keep inflation at around 2% per year.
However, when monetary policy creates a scenario in which there is a decrease in the money supply and there is no corresponding decrease in the production levels in the economy, that is, the same amount of goods are produced, then there will inevitably be a decrease in the prices of these goods.
In this scenario, there is less money seeking to buy the same number of goods. This results in an oversupply of these goods. Hence their prices will fall.
What Causes a Decline in Money Supply?
The central bank such as Federal Reserve, Bank of Canada, Bank of England, Reserve Bank of Australia, or European Central Bank is responsible for managing the supply of money but it is not necessarily always directly responsible for the decline in the supply of money.
This decline in the money supply may simply be due to a decrease in demand for goods or an oversupply of goods in the market.
Decrease in Demand
A decrease in demand for goods and services in the marketplace may be caused by the following:
– A recent market failure such as a stock market crash or housing market collapse in which many investors lost money can cause people to have less money available to spend on goods in the marketplace.
– As an extension of the previous point, a market failure will normally cause an overall decline in investor sentiment and an increase in economic pessimism about the future. Most people will therefore choose to save their funds for a rainy day. Thus, they will spend less money on goods in the marketplace.
– Higher interest rates can reduce the amount of money supply as it becomes more expensive to borrow money. As such, individuals and businesses are less likely to borrow money and spend it in the marketplace.
Increase in Supply
An increase in the supply of goods and services in the marketplace may be caused by the following:
– Too many suppliers chasing high returns and profits in a specific sector may oversupply the market. This is especially prevalent in real estate. During a housing boom, the market attracts an increasing number of real estate developers who attempt to build and sell homes in the market as quickly as possible to take advantage of the market conditions. Developers often build housing units at a rate that outpaces the size of the market demand for housing, and prices eventually begin to drop as there are no new buyers for their properties.
– New technology in a specific sector can enable producers to produce a higher number of products faster at cheaper costs. These lower production costs can be passed on to consumers in lower prices. For example, this phenomenon is common in the computing industry where newer computers and smartphones have an increasing number of technological features and are sold for lower prices than older computers and smartphones.
When Deflation is Good
At first glance, deflation sounds like a good thing. The same amount of money can buy a higher number of units of goods in the marketplace.
People effectively become richer as they can afford to buy more goods and services. This reduces their cost of living. Thus, people have surplus funds for savings and investments.
Deflation seems like a great deal for consumers.
When Deflation is Bad
On the other hand, deflation is not a great deal for producers. The prices of their products fall and they earn less revenue.
Decreasing revenues hurt the earnings and returns on investment of businesses. As such, investors in public companies are hurt by deflation.
In addition, the increased value of a currency means that individuals and businesses that borrowed money before the deflationary period are repaying their debts in money that is worth more than the money they originally borrowed. To make matters worse for a business, this more expensive debt financing that a business uses to fund its operations is producing decreasing revenue due to the drop in the prices of its products. This hurts the return on investment of the business.
A poor return on investment scares off future investors. Therefore, there is less business investment. And there are smaller returns on investment. Businesses are less likely to reinvest in their businesses or hire additional employees.
In this way, deflation is not good for an economy.
Inflation at 2% to Avoid Deflation
The supply of money is the responsibility of the central bank of a country.
Central banks set and implement monetary policy to manage the supply of money in order to keep inflation at around 2% per year. They seek to avoid deflation, which can be overall detrimental to an economy.
Deflation can cause a downward spiral of pessimism in an economy. This will discourage individuals and businesses from borrowing money and spending and investing, which will in turn continue the decline in the prices of goods and reduce the value of businesses, which will add to the downward spiral of the economy.
As such, moderate inflation, and not deflation, is the goal of almost every central bank in every country.