What Is Deflation ?
Deflation is a general, significant and sustained decline in the price level of goods and services in economics. Deflation occurs when aggregate demand is lower than the aggregate supply (sales crisis). Deflation can occur along with depression. Historically, however, there were deflationary periods associated with adequate economic growth.
Deflation is the opposite of inflation. It is characterized by a decrease in prices in the economy, resulting in an increase in the number of goods that can be purchased for national currency. For example, you make purchases of approximately the same assortment for $50 a day. A month later, the same shopping basket will cost you $48, and a month later - $46. This example shows that the purchasing power of money has increased and prices have fallen.
The most striking example of deflation affecting the entire world economy (especially the economy of the USA, Germany, France, Great Britain, and Canada) is the Great Depression from 1929 to 1939. This economic crisis began with the stock market crisis in the United States, with a sharp drop in stock prices.
The cause of this global economic catastrophe, according to more than half of economists, was exactly deflation - a decline in commodity prices due to a shortage of money supply among the population. At that time, money was secured by a gold reserve.
A catastrophic imbalance was formed between supply and demand. The result was the bankruptcy of many enterprises, credit defaults. All this, like a snowball, simply “brought down” the US economy and its economic partners.
In the 1990s, Argentina suffered from hyperinflation. To stop it, a currency board, which tied the country to the US dollar, was set up. Initially, inflation could be reduced significantly, but the state did not succeed in getting its debt under control, and above all, not enough taxes could be collected. As a result of the Asian crisis since 1998, investors also revalued Argentina and the Argentine peso as an investment opportunity and lost confidence because of the country's over-indebtedness. Subsequent foreign capital tightened the crisis, forcing the Argentine Currency Board to steadily raise domestic interest rates in order to adjust the money supply to dwindling foreign exchange reserves. High interest rates, however, caused consumption and investment to collapse and led to a sharp fall in prices (Argentina crisis). In early 2002, Argentina abandoned its exchange rate commitment.
During the course of 2013, the monthly consumer price trend (previous year) in the EU countries Bulgaria, Greece, and Cyprus fell below the zero line. In 2014, this also happened in Spain and Slovakia.
Today, steady deflation (about 1%) is observed in the Japanese economy. The government of this country is making significant efforts to reduce deflationary processes.
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Causes of Deflation
Here are the main reasons why deflation may occur:
- Production growth. The latest technology in production allows us to increase the volume of goods released for sale, which leads to the need to lower the prices. That is what, as a result of the so-called industrial revolution, happened in the 19th century - thanks to technological progress, the number of products manufactured by enterprises increased sharply, which led to a decrease in the price level - deflation.
- Tough economic policy. Sometimes, to fight inflation, the government decides to reduce the supply of money in circulation. There are several ways to do this: increase the discount rate, increase the reserve requirements of banks, increase taxes, “freeze” wages, reduce government spending, restrict loans, increase sales of government securities.
- Falling consumer demand. If the population expects an increase in the purchasing power of money, it will tend to set aside their money now in order to spend it in the future. A similar situation is called a liquidity trap.
- Reduced supply of national currency. One of the primary examples for this case is the creation of the Federal Reserve System, which led to a reduction in the money supply in the United States and thus to deflation.
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How Deflation Impacts Economy
Here’s how deflation can impact the economy:
- Lower wages and unemployment. In the event of deflation, company incomes begin to decline, so the only way out is to lower the wages and make the staff redundant.
- Lower product prices. Deflation leads to an increase in the purchasing power of money. As a result, the income level of manufacturing companies is declining. To withstand competition, enterprises are forced to reduce the cost of their products, which further escalates the unprofitable situation for business.
- Falling demand for goods. Due to lower wages and increased unemployment, the demand for goods is falling significantly.
How to Fight Deflation
Thanks to the experience of combating deflation in a number of countries, several proven methods of influencing deflation are used today. A common method is the application of soft monetary policy. The Central Bank lowers interest rates in order to revitalize enterprises with the help of credit funds. Consumers also take more loans, which increases demand, and commodity prices stabilize. The state can also ease tax pressure and increase the sales of government securities.
In the United Kingdom, the latest case of deflation was in 2015. According to The Telegraph, this was the first time in over 50 years. Experts said that this deflation was caused by a drop in the prices for energy and food commodities and was overall beneficial for the economy. They were also expecting inflation by the end of the year, but the inflation rate in 2015 was only 0.99% per 1 pound value.
Deflation is the opposite of inflation, i.e. a sharp decline in consumer prices as a result of production growth, tough economic policy, falling consumer demand, and reduced supply of national currency. The most known example of deflation is the Great Depression in the US in the 1930s. In the UK deflation took place in 2015, and it was the first time since the 1960s. Currently, Japan is experiencing deflation.
Now you know what is deflation and what are the causes of deflation. In addition to deflation definition, we have a number of other helpful financial definitions in our dictionary at enon.com. Feel free to visit our website for more information.