Deflation (economics)

Deflation is generally regarded negatively in that it is usually a symptom of a depression or severe recession. In a deflationary situation, people tend not to spend money because they are expecting prices to drop, which causes factories to close, which causes prices to drop, which causes people not to spend money, etc. Also, deflation causes people to hold on to cash rather than to invest the money. These adverse effects of deflation are arguably due to rigidities in the economy: If wages, prices and interest rates adjusted seamlessly to deflationary expectations, they would have no real economic effects.

Examples of deflation include the Great Depression and the economy of Japan during the 1990s. There was also a slow decline of the general price level in the late 19th century. During this time the gold standard was in use and known gold stocks were growing less rapidly than production. As a result, gold became more expensive in terms of goods, that is, a drop in the price level. This phenomenon ended with the discovery of gold reserves in South Africa and Alaska. With World War I, countries began to move away from the gold standard.

Causes

Deflation may be due to several reasons :

• Cheap raw material because prices have fallen (e.g. lower oil prices).
• High currency; exports become cheaper.
• Gloomy prospects, and lower consumer confidence; when consumers think that the future may be worse than the present (e.g. consumers are afraid of losing their jobs and save more than usual).
• Aging population. Aging populations tend to spend less as, for example, in Japan.

Tools to fight deflation

Basically, governments and central banks try to make consumers to buy more and save less. They can:

• Lower interest rates (where possible).
  • Borrowing is cheaper and the yield of bank accounts is lower.
  • People tend to buy shares instead of Treasury bonds (since the bond yields are lower).
  • This strategy is only possible if interest rates are not already zero.

• Lower taxes
  • Citizens have more money available.

• Devaluation of the local currency or making it cheaper.
  • This strategy increases the cost of imports, so there is imported inflation.

Deflation in the United States

There have been two significant periods of deflation in the United States. The first was after the Civil War. The second was between 1930-1933 when the rate of deflation was approximately 10 per cent/year.

Deflation in Japan

Deflation started in the 1990s. The Bank of Japan and the government did not succeed in getting rid of deflation, although interest rates are near zero. The reasons for deflation in Japan are:

• Bad loans. Banks lent money to several companies which are now in dire straits. Japanese people are afraid that banks will collapse so they prefer to buy gold or Treasury bonds instead of saving their money in a bank account.
• Deflation exported from China. Since Chinese raw materials and wages are lower, prices of manufactured products tend also to be much lower.

See also:

• Stagflation
• Hyperinflation
• Macroeconomics

• http://wiktionary.org/wiki/Deflation

Referenced By