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Guide to Understanding Deflation

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Causes of Deflation in Economics

An economy in a state of deflation is characterized by the price of its goods and services declining over an extended period of time.

In the beginning, consumers can benefit from increased purchasing power, meaning that more goods can be bought using the same amount of money.

While the initial price decrease might be viewed positively by certain consumers, the negative effects of deflation gradually become more pronounced over time.

Deflation can go hand-in-hand with an impending economic downturn, often signaling that a long-lasting recession might be on the horizon.

While prices decline, the spending behavior of consumers tends to change, wherein purchases are intentionally delayed in anticipation of steeper discounts, i.e. consumers begin to hoard cash.

The slowdown in consumer spending frequently accelerates a transition to an economic downturn because companies selling products generate less revenue.

In addition, the interest rate environment can affect the severity of the effects of deflation on the broader economy.

Deflation is caused by the following two factors:

  • Excess Aggregate Supply
  • Reduced Aggregate Demand (and Less Consumer Spending)

Consequences of Deflation

Deflationary periods are often attributed to a long-term contraction in the supply of money circulating in the economy.

The economic contraction indicative of deflation can be triggered by reduced spending from consumers, which can result from consumers waiting for prices to continue to decline.

Some adverse long-term effects of deflation include:

  • Reduced Aggregate Demand (Less Consumer Spending)
  • Higher Interest Rates and Contraction in Credit Markets
  • Increased Unemployment Rates and Lower Wages
  • Less Profitable Companies
  • Long-Term Slowdown in Economic Production Output
  • Negative Feedback Loop Triggered by the Lower Consumer Spending
  • Portfolio Values Decline
  • Increased Number of Defaults and Bankruptcies

While the economic output may remain the same in the early stages of deflation, eventually, the decrease in total revenue negatively affects a country’s employment statistics (i.e. higher unemployment) and more bankruptcies, among other consequences.

The credit markets also contract as the demand for credit from consumers and companies exceeds the supply, i.e. credit becomes limited with unfavorable financing terms as lenders are weary of the growing default risk of borrowers and are bracing for an impending recession.

Another factor contributing to deflationary risk is increased productivity and efficiency (e.g. the integration of software/tech in traditional industries), which maintains the total level of economic output in line with or above historical levels despite requiring less labor.

Short periods of declining prices can be positive for an economy with minimal long-term damage.

The issue that tends to lead to an economic shock is the credit environment of the economy, i.e. the amount of debt utilized by consumers and companies.

Suppose a country’s producers possess excess supply, where the number of products on hand to sell to consumers exceeds the demand from consumers.

In the scenario above, the companies that produce the goods and sell them have no choice but to undergo operational restructuring to remain profitable or cut their prices to sell more goods.

Debt Deflation Theory

In theory, the negative effects of deflation are closely tied to an expansion in the real value of an economy’s debt, which includes the borrowings by consumers, corporations, and governments.

If a highly levered credit environment is coupled with deflation, the number of defaults, bankruptcies, and limited liquidity can result in a recession, especially if the financial health of the country’s banks is unstable.

Since companies cannot increase prices in a deflationary period — i.e. demand is already low — their method of survival is typically via operational restructurings, such as cost-cutting, reducing employee wages, and shutting down non-essential functions.

Companies in cost-cutting mode also frequently try to extend their days payables (i.e. the number of days between receiving the goods and the date of cash payment), as well as negotiate terms that are less favorable to suppliers.

These short-term measures might temporarily reduce the burden faced by companies, yet these actions contribute to an even more significant downward spiral in the economy.

Inflation vs. Deflation

Contrary to deflation, inflation describes periods in which the price of goods rise, resulting in a widespread reduction in purchasing power across consumers.

While consumers can purchase more for the same amount of money and the value of the country’s currency rises over time under deflation, the opposite occurs in inflationary periods, when fewer goods can be purchased using the same amount of money, and the currency becomes devalued.

Inflation and deflation in an economy are each caused by an imbalance in the supply and demand within the country.

  • Inflation → Aggregate Supply < Aggregate Demand
  • Deflation → Aggregate Supply > Aggregate Demand

Inflation can be caused by decades of low interest rates, as currently seen in the U.S. economy in 2022, which was worsened by the pandemic (and the unprecedented monetary policies where capital flooded the markets at very low-interest rates).

On the other hand, deflation can result from rising interest rates. For instance, the central bank could implement a tighter monetary policy where interest rates are increased.

Rising interest rates in an economy cause lower levels of borrowing from consumers and companies, along with reduced overall spending.

Deflation is commonly perceived as a sign of a looming recession, which can cause a noticeable economic slowdown.

From the perspective of certain economists, deflation is actually worse than inflation, since the ability for the central bank to step in is more limited.

Given the fewer tools on hand and how interest rates can only be reduced to zero (with negative interest rates remaining highly controversial), a so-called “liquidity trap” can occur, as observed with Japan’s economy.

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