Updated Feb 18, 2022

What is Deflation?

What is Deflation?

Most people have heard of the word ‘inflation’ and are aware of how it works or what its implications are. However, not as many people are aware of deflation and how it can affect them. The common misconception is that deflation, meaning a considerable drop in prices across the economy, is a good thing. But the reality is actually the opposite.

What Is Deflation?

Deflation is essentially a notable decline in prices across the general economy. It is associated with a contraction in credit and money supply in the economy. As a result, the currency purchasing power steadily goes up. Other reasons for deflation can also be a general increase in productivity or technological advancements.

Due to deflation, the associated nominal costs for labour, capital, goods and services see a drop, even if the relative prices do not see a big change. At face value, consumers may find deflation beneficial because the same nominal income now has more purchasing power. However, a consequence of deflation on various sectors can lead to an adverse effect on borrowers who have to return more money with a greater value than the initial borrowing. It also impacts investment prospects in the financial market.

What Are The Causes Of Deflation?

Deflation can be caused by multiple factors:

• Changes in capital markets structure: When companies providing identical goods or services compete, they seek to cut prices in order to gain a competitive advantage.
• Higher propensity to save: People start saving instead of spending in the hope of a future fall in prices. This reduces the demand and the prices further drop.
• Productivity gains: Innovation and technology allow for greater manufacturing efficiency, resulting in cheaper prices for goods and services.
• Reduced currency supply: As the quantity of currency decreases, so will the prices of products and services, making them more affordable to individuals.

What Are The Effects Of Deflation?

Deflation in an economy means that things are becoming worse. Following are its effects:

Low Growth: 

Deflation is usually associated with high unemployment and low levels of production of products and services.

Reduced Revenues in the Business: 

To stay successful in a deflationary economy, firms dramatically lower the pricing of their products or services. Revenues begin to decline as prices are reduced.

Reduced Wages and Layoffs: 

As sales decline, firms find ways to cut costs in order to reach their goals. One method is to reduce wages and layoffs. This has a negative impact on the economy since consumers will have less money to spend.

Reduces consumer spending: 

When prices are falling, people will more likely to postpone purchases in the future because they will be cheaper.

Increase the real value of debt: 

Deflation increases the real value of money and debt. Debtors find it more difficult to repay their debts as a result of deflation. As a result, consumers and businesses must devote a greater portion of their disposable income to debt repayment. (In a deflationary period, firms will receive lower revenue, and consumers will likely receive lower wages.) Negative inflation would make it difficult for Indian corporations to repay debts as their debt burden would rise.

Real wage unemployment:

 'Sticky wages' are common in labour markets. Workers, in particular, are resistant to nominal wage cuts (no one likes to see their wages reduced, especially when they are accustomed to annual raises). As a result, real wages rise during deflationary periods. This could result in real-wage joblessness.

No incentive to produce: 

Producers, whether in manufacturing or farming, require inflation to increase their profits. If prices fall, producers will cut back on production, resulting in a supply shortage in the long run.

However, there is also one Positive Effect of Deflation:

Greater Export Competitiveness: 

If most other economies are suffering inflation, a positive effect of deflation could be increased export competitiveness. Exports will be profitable as the rate of products and services falls.

Measures to address Deflation

• Government should follow a Cheap/Easy/Dovish Monetary Policy to make loans cheaper.
• Individuals should be provided with tax deduction/subsidy types of benefits to encourage the purchase and expenditure.
• Government should increase the expenditure on public projects eg. Highways, dams etc. to boost demand in the steel/cement industry. This will also get people employed and their purchasing power will increase, this will increase the demand and the general price levels can be then attained.

Types Of Deflation

Two main types of deflation are ‘good deflation’ and ‘bad deflation’

Good Deflation:

Deflation due to lower costs is called good deflation. A rapid increase in productivity can lead to lower prices without reducing the supply of goods and services and opening up the potential for great profits. In theory, this can then help in increasing wages. A bigger disposable income will also contribute to more spending, keeping the cycle going.

Bad Deflation

Bad deflation is that which is caused due to a reduction in demand. Low demand leads to dropping prices, causing loss instead of profit. Thus wages will be reduced and employees laid off. Hence, spending will decrease as will consumption. While waiting for prices to fall low enough for the goods to be affordable, the economy will see a massive slowdown.

Why Does Deflation Matter?

While deflation is the opposite of inflation, the impact can be just as serious. Since deflation, much like inflation, can turn into a vicious cycle the whole economy can suffer. When prices in the economy continue to see a decrease, consumers’ spending is withheld while they wait for prices to reach an optimal number. So demand continues to decrease, contributing to deflation further. The whole economy may see a standstill and put innovation and overall growth on hold.

Conclusion

India is familiar with inflation and has also undergone periods of deflation. This phenomenon can impact the government, consumers and businesses in different capacities. It can also make debt financing an unviable option. However, it can benefit savings-based equities. For investors, businesses that have little debt or hold large reserves of cash offer more lucrative investment options. Deflation may also increase the risk premium for securities and yields that are rising.

Proportionate deflation can be very beneficial for the economic growth of a country, not to mention it has the potential to improve the average consumer’s standard of living. In excess, it can drastically reduce spending capacity and worsen economic crises in the country. Hence, the government does its best to establish measures that can help combat such adversities and minimize the impact while still keeping the country’s economic interest in mind.