Sep 27 2012

Deflation: why lower prices spell doom for any economy!

The Fed should focus on deflation | The greater of two evils | The Economist

Deflation: a decrease in the general price level of goods and services of an economy. Sounds great, right? Lower prices mean the purchasing power of our income increases, making the “average” person richer! On the surface, it could be concluded that deflation may actually be a good thing. And in some cases, it is!

If prices of goods are falling because of major technological advances (think of the price of cell phones and laptop computers over the last 20 years) or because of massive improvements in the productivity of labor and capital (think of the price of manufactured consumer goods during the Industrial Revolution), then deflation could be considered a sign of healthy economic growth. Put in terms an IB or AP Economics student should understand, a fall in prices caused by an increase in a nation’s aggregate supply is good, since it is accompanied by greater levels of employment and higher real incomes. But if the fall in prices is caused by a decline in spending in the economy (in other words, by a decrease in aggregate demand), the consequences can be catastrophic.

It just so happens that the United States, Great Britain, and my own home of Switzerland are all faced with demand-deficient deflation at this very moment. I’ll allow the Economist to elaborate:

…With unemployment nearing 9% (in the United States), economic output is further below the economy’s potential than at any time since 1982. This gap is likely to widen. House prices are not part of America’s inflation index but their decline is forcing households to reduce debt , which could subdue economic growth for years. As workers compete for scarce jobs and firms underbid each other for sales, wages and prices will come under pressure.

So far, expectations of inflation remain stable: that sentiment is itself a welcome bulwark against deflation. But pay freezes and wage cuts may soon change people’s minds. In one poll, more than a third of respondents said they or someone in their household had suffered a cut in pay or hours…

Does this matter? If prices are falling because of advancing productivity, as at the end of the 19th century, it is a sign of progress, not economic collapse. Today, though, deflation is more likely to resemble the malign 1930s sort than that earlier benign variety, because demand is weak and households and firms are burdened by debt. In deflation the nominal value of debts remains fixed even as nominal wages, prices and profits fall. Real debt burdens therefore rise, causing borrowers to cut spending to service their debts or to default. That undermines the financial system and deepens the recession.

From 1929 to 1933 prices fell by 27%. This time central banks are on the case. In America, Britain, Japan and Switzerland they have pushed short-term interest rates to, or close to, zero…

…inflation is easier to put right than deflation. A central bank can raise interest rates as high as it wants to suppress inflation, but it cannot cut nominal rates below zero… In the worst case, rising debts and defaults depress growth, poisoning the economy by deepening deflation and pressing real interest rates higher….Given the choice, erring on the side of inflation would be less catastrophic than erring on the side of deflation.

Discussion Questions:

  1. Deflation poses several threats to an economy that is otherwise fundamentally healthy, such as the United States’. What are some the threats posed by deflation?
  2. The expectation of future deflation can have as equally devastating effect. Why is this?
  3. What evidence does the article put forth that an economy experiencing deflation may eventually “self-correct”, meaning return to the full employment level of output in the long-run?
  4. Why don’t governments and central banks just sit back and let the economy self-correct? In other words, why are fiscal and monetary policies being used so aggressively by the US, Great Britain and Switzerland during this economic crisis?

Deflation or Inflation:Watch the video below, see if gives you any clues as to the causes and effects of deflation. What do you think John Maynard Keynes would say in response to the deflationary fears expressed in the Economist article?


About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

65 responses so far

65 Responses to “Deflation: why lower prices spell doom for any economy!”

  1. diana.ecsl1.f09on 09 Dec 2009 at 8:14 am

    Ben that's a great answer to the fourth question. I like how you mentioned sticky wages. I hadn't thought of the difficulty to decrease wages, only to increase them.

  2. diana.ecsl1.f09on 09 Dec 2009 at 8:17 am

    Alison that is an excellent and very detailed answer for #2. That definitely is a Neo-classical viewpoint, that the economy can correct itself without the help of the government. Great job comparing and contrasting Neo-classical and Keynesian arguments on the issue.

  3. Olajumoke.ecslb.f09on 22 Dec 2009 at 8:21 pm

    1. Deflation due to a lack of government spending could lead to a rise in unemployment and a fall in AD.

    2. This is because consumers will not spend in order to spend later when prices are lower. By anticipating the deflation, the consumers are only speeding its arrival and aggravating the problem.

    3. This article does not really present valid evidence that the deflation will eventually self-correct and it actually seems to predict that doom will occur if this problem continues

    4. These policies are being used because these governments remember that it was only due to government intervention that they pulled themselves out of the Great Depression. Based on that experience, the best course of action is reflationary policy.

  4. Olajumoke.ecslb.f09on 22 Dec 2009 at 8:24 pm

    Response to diana.ecslb.f09:

    As much as I appreciate your point in question 3, I must stress that even if the deflation is not anticipated, it will probably still occur. The fact that people expected the inflation to continue rising in the USA, they still got into a recession and it surprised the people which actually worsened its effect.

  5. Isabelle Yon 10 Mar 2011 at 2:46 am

    1. Deflation will increase the value of debts, and many companies will find they are unable to repay loans. In addition to that, business may experience low profits as an effect of deferred consumption. As profits fall, business confidence may fall which will cause they to lay off workers, and thus the deflation spiral begins as consumer confidences fall and aggregate demand is further depressed. In the worst case, this could many firms to bankruptcy and consumers to poverty.

    2. If consumers expect future deflation, they will want to wait until prices fall further before spending their money. This is called deferred consumption.

    3. The article suggests that consumers' mindsets may cause they to believe that inflation is bound to occur in the future, which may actually lead to an increase in AD when price levels fall. This quickly brings AD back up.

    4. The governments don't want aggregate demand to fall so slow that the economy becomes heavily disabled like during The Great Depression where consumer's purchasing power was minimal and unemployment was so high. Without government intervention, it might take too long for the economy to 'self-correct'. In the keynesian perspective, an economy in a deep recession will not be able to be saved by market forces alone – the government has to increase spending to kickstart an increase in AD again

  6. LI JUNFENGon 10 Mar 2011 at 6:03 am

    1.The deflation will cause effect on unemployment and investment. Because the aggregate demand is low, so the firms might take action to lay off workers. And then consumer confidence and business confidence will be low, and a deflationary spiral occur. Furthermore, deflation will increase the value of debs, and worsen business confidence, and firms are unable to pay loan back.

    2.A deferred consumption caused by the consumers expectation. If price is falling, then the consumer will want to wait to spent their money until the price drop even further.

    3.The article suggest consumer knows the uncertainty of the future and which aggregate demand will increase again.

    4.Because it takes a very long period for the economic to set back and self-correct. Therefore, government wants to intervene so that the aggregate demand can fall rapidly. In Keynesian perspective, government use demand-side policy and so shift the aggregate demand so that increase the consumption and employment rate.

  7. Erick Chanon 14 Mar 2011 at 5:11 pm

    1. When there's a deflation, the aggregare demand is low, causing more unemployments. More people compete for scarce jobs, and the workers' wages would be decrease. People are poorer, but the nominal value of their debts remained, which gives them higher burdens. People with higher debt burden would save their money for repaying the debt, in stead of spending them. Because of low aggregate demand, firms for sure would not take such high risk to invest. Therefore, the aggregate demand remain low, and the deflation boosts, if the situation doesn't change, eventually it may cause a recession. What a vicious spiral!

    2. If people expect a future deflation, they may keep their money unit the deflation happen, in order to buy goods in a lower price. During this period, the demand would be low, making prices lower, as well as the quantity supplied, which affects the level of output. Eventually, a deflation really happen.

    3. The article suggests that the deflation may "self-correct" if the interest rate keep low. As the interest rate is low, people with spare money would tend to spend more rather than saving them in banks for little interest, and the costs of borrowing money is low, which encourages households and firms to borrow money for fixed assets or investment, and make the aggregate demand increase. So eventually, the economy would slowly stand up in the long run.

    4. Because a "self-correct" of economy happens in a long duration of time, in this long period of time, the country's economy would fall behind as others' are growing. Which means the country is "sleeping", and the distance between it and other foreign countries is enlarging. This is not appreciated for any country. So, if a country doesn't want to lag behind in economy, it should make effort to get itself away from recession, as fast as possible.

  8. Ashraf Zainalon 16 Mar 2011 at 4:16 pm

    1) Deflation poses several threats to an economy that is otherwise fundamentally healthy, such as the United States’. What are some the threats posed by deflation?

    One of the main threats of having deflation in an economy is that businesses and firms of all kinds will earn less money. By having this problem, other issues may arise as well such as having an increase an unemployment. Since the firms earn less money, this problem may make them become pessimistic about the economy, which then causes them to lower the costs of production. Unfortunately, one of the main methods of lowering the costs of production would be to lay off workers and this would mean that they have to pay less wages, but the level of unemployment in the economy will increase. Other issues of deflation include having a lowering economy and lower economic activity.

    2) The expectation of future deflation can have as equally devastating effect. Why is this?

    If both firms and consumers are expecting future deflation, then there are two things that may happen. Firms will expect to lay off workers to lower the costs of production, and the consumers will want to save as more money because of the risk of being unemployed and to spend their money in the future when the prices of goods are lowered. This would cause having an increase in the level of withdrawal and less injections to the economy.

    3) What evidence does the article put forth that an economy experiencing deflation may eventually “self-correct”, meaning return to the full employment level of output in the long-run?

    Although deflation is a situation that governments may have to intervene with, this article brings about evidence that deflation may also eventually self correct itself. This is because if the level of interest rates are lower, consumers theoretically will spend more than save, which would then push the Aggregate Demand positively and hence causing an decrease in the level of unemployment.

    4) Why don’t governments and central banks just sit back and let the economy self-correct? In other words, why are fiscal and monetary policies being used so aggressively by the US, Great Britain and Switzerland during this economic crisis?

    During an economic crisis, the economic growth of a country will be much slower than normal. This means that the aggregate demand is low and that the level of unemployment is high. Most countries would not choose to let the economy self correct because even though when the prices may lower and the consumer spending may increase, it is still necessary for the economy to have some government spending. This is because the only way to shift the Long Run Aggregate Supply (LRAS) positively is if the government increases its spending. This is shown in the keynesian graph. Fiscal policies deal with having the government spending to increase in its public goods/ merit goods such as healthcare, education, etc. The monetary policy refers to the interest rates, which is controlled mainly by the central bank. By controlling the interest rates, the central banks may be able to push consumers' incentives to spending more or spending less. This is to control the level of inflation.

  9. Kenon 16 Mar 2011 at 5:06 pm

    If the fall in prices is caused by a decline in spending in the economy, that means there will be a decrease in AD. Some threats caused by deflation may include unemployment (more people compete for scarce jobs, result in a low wages). Besides, investors will unlikely to invest in economy due a drop in the disposable income.

    If prices are falling, consumers will put off the purchase of any durable goods as they will want to wait until the price drop even further. This may be reffered to as deferred consumption.

    This article suggests that an economy experiencing deflation may eventually “self-correct” as a result of cuts in spending by firms, this will in turn increase AD.

    This referes to the disavantage of demand side policy. In theory, the time taks for an economic to set back and self-correct is huge, and no one knows how bad the economy would get before it self-correct

  10. Se Uk Shinon 16 Mar 2011 at 6:00 pm

    The effects that deflation will cause can change the economic states drastically. if deflation happens by increase in AS, in this case it is positive. However, if deflation took place by Demand side, this can be an issue. For example, this will cause increase in unemployment rates and the firms will not tend to invest because they normally have pessimistic ideas towards the future. This lower in investment will gradually affect the economy.

    Deflation can have devastating effects on both firms and consumers. first of all, as i mentioned before, there will be more unemployment because firms tend to have lower wages than before. this means that household has more possibility to lose jobs. Secondly, firms will not earn as much as they used to because of deflation. as they earn less, they may lose their confidence in business and this will cause firms not to invest.

    Even though there is a deflation take place, economy will self-correct because in economy, when something changes, there are other responsiveness. in this case, deflation will differ the AS and AD curve. however there are other factors that can change the AS and AD. Thus these AS and AD curves will come back to be stable again.

    This is because there is a lot of time consuming for economy to be stable again without government intervention. with government intervention, the economy can come back to the stable point rapidly.

  11. Bedemand Holbækon 23 Nov 2014 at 6:20 am

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    Deflation: why lower prices spell doom for any economy! | Economics in Plain English

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    Deflation: why lower prices spell doom for any economy! | Economics in Plain English

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