Deflation and Falling Prices

Effects of Deflation

Deflation is defined as a sustained and broad decline in price levels in an economy over a period of time. Deflation is the opposite of inflation and is also different from disinflation, which represents a period when the inflation rate is positive but falling.

The biggest problem created by deflation is that it leads consumers to defer consumption, not with regard to the daily necessities of life like groceries, but for big-ticket items like appliances, cars, and houses. After all, the possibility that prices may go up is a huge motivator for buying big-ticket items (which is why sales and other temporary discounts are so effective).

You might think this is good news. After all, as wages and salaries stagnate, declining prices means an increase in people’s real purchasing power. Global commodity prices, including of crude oil, have corrected significantly and this augurs well for India, which has been struggling with high inflation for years. The fall in commodity prices is helping the overall policy stance of containing prices. While India is celebrating the disinflationary process, the decline in general price level, or slower than warranted increase in prices, is creating a fair amount of economic uncertainty in other parts of the world.

Problem with falling prices

Once consumer spending begins to decelerate, it has a ripple effect on the corporate sector, which begins deferring or slashing capital expenditures—spending on property, building, equipment, new projects, and investments. Corporations may also begin downsizing the workforce in order to maintain profitability. This creates a vicious circle, with corporate layoffs imperiling consumer spending, which in turn leads to more layoffs and rising unemployment. Such contraction in consumer and corporate spending can trigger a recession, and in the worst-case scenario, a full-blown depression.

There are actually three different reasons to worry about deflation, two on the demand side and one on the supply side.

• So first of all: when people expect falling prices, they become less willing to spend, and in particular less willing to borrow. After all, when prices are falling, just sitting on cash becomes an investment with a positive real yield and anyone considering borrowing, even for a productive investment, has to take account of the fact that the loan will have to repaid in rupee that are worth more than the rupee you borrowed. If the economy is doing well, all this can be offset by just keeping interest rates low; but if the economy isn’t doing well, even a zero rate may not be low enough to achieve full employment.
• And when that happens, the economy may stay depressed because people expect deflation, and deflation may continue because the economy remains depressed. That’s the deflationary trap we keep worrying about.
• A second effect: even aside from expectations of future deflation, falling prices worsen the position of debtors, by increasing the real burden of their debts. Now, it may look like a zero-sum affair, since creditors experience a corresponding gain. But usually debtors are likely to be forced to cut their spending when their debt burden rises, while creditors aren’t likely to increase their spending by the same amount. So deflation exerts a depressing effect on spending by raising debt burdens – which can lead to another kind of vicious circle, in which depressed spending because of rising real debt leads to further deflation.
• In a deflationary economy, wages as well as prices often have to fall – and it’s a fact of life that it’s very hard to cut nominal wages — there’s downward nominal wage rigidity. What this means is that in general economies don’t manage to have falling wages unless they also have mass unemployment, so that workers are desperate enough to accept those wage declines.

Conclusion

The lower than desired level of inflation is an indication of weak demand and weaker economic activity. But if prices begin to decline, economic activity will suffer even more. Consumers will postpone spending as things are likely to get cheaper at a later date. Firms will not invest in capacity expansion because of falling demand and lower expected returns on investment due to falling prices. Indebted companies and governments will cut investment and expenditure to repay debt, which will rise in real terms because of the falling revenue.

Overall, the economic activity will be hit and the economy will go into a downward spiral, affecting the level of output, income, employment and standard of living. Therefore, it is important for policymakers to avoid such a situation.