Deflation
Deflation is the opposite of inflation, which means that prices of goods and services decrease and the purchasing power of the currency increases. Deflation usually results from a reduction in the supply of money and credits in the economy.
Understanding Deflation
At the time of deflation, the relative prices of capital, labor, goods, and services may not change, while the nominal costs of them decrease. Because of the ability to buy more products for the same money, deflation seems beneficial for consumers.
But price decreases do not benefit everyone. Falling prices cause some negative effects in different sectors of the economy, especially the financial one. For example, borrowers can suffer from deflation. They are forced to pay off their debts with money that cost more than the money they borrowed earlier. Also, market investors or speculators on the price increase perspective suffer.
Causes of Deflation
Initially, only a reduction in money or financial instruments supply can cause deflation. In turn, the supply of money is under central bank (such as the Federal Reserve) influence, and in the absence of a decrease in economic output, it leads to a fall in the prices of all goods. Deflation most often follows after a long artificial monetary expansion. The last significant deflation in the U.S. was in the early 1930s. It was caused by a contraction of the money supply after catastrophic bank failures. More recently, the 1990s Japan experienced deflation.
The monetary policy rule came from Milton Friedman's theory. According to this theory, if the central bank tends to a deflation rate equal to the real interest rate of government bonds, then the nominal rate should be 0 and the price level should fall at the real interest rate. This is supposed to be the optimal policy.
But other factors also have an impact on price reductions. For example, productivity growth and reduced aggregate demand for goods and services (and then falling prices). Such shifts are based on a reduction in government spending, the consumers' tendency to save money, the stock market crash, and a tightening of monetary policy (interest rate an increase).
The growth of production in the economy, outpacing the supply of circulating money and credits, causes the natural fall in prices. The efficiency of producers increases as technology develops. Technological improvements in certain goods and industries most often increase the economy's productivity by reducing production costs and saving money. As a result, low prices for consumers are achieved. This differs from general price deflation, representing a decrease in the price level and an increase in the purchasing power of money.
Deflation of prices due to productivity improvements occurs differently in different industries. For example, as a result of development and improvement in the technology sector, the average cost per 1 gigabyte of data has dropped significantly from $437,500 in 1980 to 3 cents in 2014. As a consequence, the prices of manufactured goods with this technology have also fallen significantly.
Changing views on Deflation’s influence
Deflation has long been considered an unfavorable condition. Especially after the Great Depression, when monetary deflation was combined with high unemployment and rising defaults. Because of this, the majority of central banks made revisions in monetary policy to consistently increase the money supply, even if this made chronic price inflation and debtors borrow too much.
British economist John Maynard Keynes concluded that falling asset prices are causing owners to reduce their desire to invest. In fact, he was wary of deflation because of its impact on the downward cycle of economic pessimism in recessions.
Economist Irving Fisher has a theory of economic depressions based on debt deflation. According to this theory, a greater decrease in the supply of credit in the economy comes after the liquidation of debt from a negative economic shock. This causes a bigger reduction in the supply of credit in the economy, which can lead to deflation. After this deflation, there is even more pressure on debtors, which leads to even more liquidation and outgrowth into a depression.
A study of 17 countries over 180 years by Andrew Atkeson and Patrick Kehoe disputed old theories about deflation in 2004. Their study stated that 65 of 73 episodes of deflation were without economic recessions, and 21 of 29 depressions were without deflation. These days, there are quite many ideas presented about price deflation and its usefulness.
Deflation changes debt and equity financing
Deflation has a positive influence on the increase in yields and necessary risk premiums on securities. It is the main reason for the increasing economic power of equity financing based on savings. It is also the main reason why debt financing is less profitable for states, businesses and consumers.
Deflation makes companies with low cash reserves and high debt look bad to investors. And companies with large accumulations of cash reserves or lower relative debt seem more attractive to investors.
