Deflation is a process in an economy where prices decrease over a period of time. A direct consequence of that is an increase in the purchasing power of the national currency.
As an example, let’s consider a minimum food basket, which initially costs $10 a day, a month later the same basket costs $9.57, and a bit later it costs $9.14. This process of decrease in prices with an increase in purchasing power is called deflation.
Any country can face deflation, so it is important for citizens to understand what can happen with the economy in this scenario. One of the most famous examples of deflation is the US’s Great Depression. It affected the economies of all countries of the world and caused a financial crisis, one aspect of which was the stock market crash. It was a true disaster; prices slumped due to the lack of money supply as the amount of money in the economy was tied to the country’s gold reserves. That resulted in enterprise bankruptcies and numerous loans leading to major problems in the US economy.
Another salient example is Japan in the 1980s in the context of their post-war economic recovery. The improving welfare provided stable demand for production; however, over time the volume of goods began to significantly exceed consumer appetites. Households became oversaturated and the nation’s demand decreased sharply causing the monetary deficit, widespread closure of manufacturing companies, and general unemployment.
The Main Causes of Deflation
Sometimes even positive processes in the economy can lead to deflation. The decline in prices can occur for a number of reasons:
- Competition for buyers
- Decrease in seasonal products prices
- Decrease in raw materials prices
- Modernization of technologies
If there is an imbalance in the economy, it can cause deflation with negative consequences and a reduction in the money supply. The main reasons for this are:
- Cash surplus due to lower prices
- Decrease in the available amount of money leading to a cash shortage in relation to the volume of goods and services produced in the country
The Consequences of Deflation.
First of all, let’s look at the causal chain. It all starts with deflation: prices go down, purchasing power goes up, then we see a complete lack of motivation to invest, purchasing demand goes down, average prices go down making the production of goods unprofitable, therefore, production goes down, unemployment goes up, GDP is falling, then there is a recession, and then there is depression. Based on that, we can conclude that high deflation is not at all good for the economy but it is rather its worst enemy.
Methods of Combating Deflation
The government is most interested in preventing deflation from progressing; therefore, we will give examples of workable methods within the framework of monetary policy:
- Government increases its expenditures and makes direct injections into the economy
- Taxes are lowered while investments in production are increased, which keeps industry afloat
- The Central Bank lowers lending rates for enterprises and the entire population in general
In conclusion, we would like to emphasize that deflation is an extremely dangerous factor in the economy and modern economic science is just learning to mitigate it. A sharp rise in deflation can bring depression and stagnation to an economy, so it is a mistake to believe that deflationary processes are better than inflationary ones. The rate of increase in prices of up to two percent per year is considered an indicator of a healthy economy.