What is Deflation? What are the Causes of Deflation?
What is Deflation?
Deflation is the macroeconomic state of a nation’s finances when assets and other consumer prices fall over time. From the surface, it might seem like it is a good thing for shoppers and other retail goods providers. But, it is only good for a short amount of time, and in the long run, it leads to lower demand for products and less money circulating in the market.
Furthermore, with deflation, the government also signals an impending recession, which causes a decline in average wages, job market suffering, and investment portfolios will be taking in some big hits during the deflation period. In addition, with deflation getting worse, you will also see recession getting out of control across the nation. Businesses will panic and start providing heavy discounts on their services and products in an attempt to give consumers a false sense of purchasing power.
What are the Causes Of Deflation?
There are three main reasons for the deletion, and since 2000 it has possessed a much more significant threat to the nation’s economy than inflation.
- The first reason for deflation is the fall in China’s manufacturing costs due to cheap labor. The country is well known for having a low standard of living so that it can pay its workers less. On the other hand, China is always pegging its currency with the dollar making its exports quite competitive.
- In the internet age, anything can be found on the web in mere seconds of searching time. As a result, workers are spending less time doing research and more on creating products or services. The whole foundation of the internet helped streamline business communications, making them as less time-consuming as possible. Many aged individuals are still working in companies at low wages to provide bread and butter for their families. They are accepting lower wages for the price of cutting down their incomes.
- Lastly, negative impact on the economy, such as recession, also leads to a decrease in aggregate demand for goods and services. When a recession is going on, people become more pessimistic about the nation’s future. As a result, they will try to increase their savings and stop investing money.
Effects Of Deflation
Deflation is considered to be one of the worst economic events a country can face.
Given below are some of the main effects of deflation that nation as a whole has to go through.
- The unemployment rates will be skyrocketed.
- Deflation leads to an increase in interest rates which results in an increase in the real value of debt.
- Deflation triggers a chain reaction that leads to much lower production, low wages, a decrease in demand from consumer ends, and more.
How To Measure Deflation?
There are two methods to measure the impact of deflation, the first one being the Wholesale Price Index (WPI) and the second Consumer Price Index (CPI). Keep in mind with CPI, you won’t be able to factor in stock prices which are considered to be an important economic indicator. For example, retired professionals often invest their money in stocks to make stock purchases. At the same time, a business will be using this investment for its fund growth. As a result, measuring deflation has to be done by calculating the WPI instead of CPI in most cases.
WPI is the difference between the wholesale price and the retail price. These will include prices that are charged by the manufacturer, and they are reported monthly to track down the overall rate of change in the manufacturer’s costing and the wholesale pricing. The index is set to 100 for the base period, and it will be calculated on subsequent price changes to find out the aggregate output of the goods.
For explanation purposes, let’s take January 2022 as the base period. Now during this time, if the aggregate prices of goods go up to 10.5% over the next year. Then WPI for January 2023 is going to be 110.5.
Deflation Changes Debt and Equity Financing
Companies and consumers pay more for loans, limiting funding. This may increase loan defaults and reduce bank trust.
A company must make huge profits to maintain its earnings-to-price per share ratio, which increases equity financing costs. This can push struggling companies to bankruptcy and discourage investors from buying their products or services.
Debt, Speculation, and Debt Deflation
Deflation results from goods and service excess. Deflation might hurt debtors, but investors can profit.
Deflation lowers prices, making it harder to repay loans. Their balance increases when someone can't pay more or less than promised. Debt deflation causes depression.
It would help if you grasped how this works to take advantage of opportunities and prevent financial surprisesation.
You can profit from deflation by buying cheaper assets with bank money. Invested money appreciates with time. Before your firm loses value, sell it, primarily if other firms perform better than you. You may buy shares and make additional money.
Deflation vs. Disinflation
Deflation causes downturns.
Assume unemployment. $50,000 became $15,000 45% less profit. If you can't save, you may default on bills, groceries, and other monthly expenses (e.g., buying generic drugs instead of brand names).
If assets fall 10% while inflation falls 5%, they have less buying power (actual returns). This implies less money for houses, vehicles, and vacations, hurting consumers and businesses.
Deflation doesn't hurt stocks (because prices fall with fewer buyers), but consumers spend less. A recession might reduce business stocks.
Monetarists stop deflation. The Fed may decrease rates, raise reserve requirements, and buy bank bonds for inflation.
Budgets can curb deflation.
Try structural measures if monetary and fiscal fail. Structural reforms include price controls on certain goods, flexible exchange rates, wage freezes, price indexation (to prevent prices from falling), indirect taxation like selective excise duties on luxury items, public works projects, agriculture or industry subsidies, and export promotion schemes like import quotas or tariffs on foreign products entering domestic markets.
How Deflation Has Played a Role in History.
Great Depression deflation was the most notable. After WWI, mechanization and efficiency of manufacturing increased production but cut non-technical incomes (or acquired skills). Because people had less money or salaries didn't keep up with inflation, several enterprises folded. Product and service demand drops when more people lose employment to closures/bankruptcies.
Why Deflation Is Worse Than Inflation
Falling prices are deflation. Deflation lowers prices but damages the economy.
Inflation results from more money or credit than goods. Since salaries and loans don't change, inflation affects actual income growth. Prices become onerous if they rise faster than earnings (e.g., if you borrow at 5% interest and your income rises at 3%). Inflation benefits shopping and hurts retirees. As prices rise, they can't afford food.
The Rare Times When Deflation Is Good with examples
- Deflation may keep consumer prices low when the economy grows, and money is plentiful. This lowers prices for companies and customers.
- Deflation is excellent for you if you're an investor who doesn't want their wealth to erode over time (which would happen if inflation were higher than your savings account interest rate).
- Deflation may be good if there are no bubbles to burst; if everything is running smoothly, there's no reason for people to fret about losing their money by holding onto it instead of investing it.
How do you profit from deflation?
Buy deflationary items to profit. This makes it reasonable because gold owners can purchase items. Buy deflationary companies. If a competitor develops a cheaper product, you must lower your pricing and earn less per unit. Say you manage an ice cream parlor, and all of your competitors have lowered their rates by 30%, but you haven't since no one else does in your town (unrealistic). Since a store across town offers ice cream for cheaper, customers won't come to yours.
So this is how economic deflation crumbles a nation; it is as much worse as inflation. During the deflation of the economy, remember not to go with panic selling of your stocks to make up the money for your savings. Over time deflation will be reduced, and your share prices will again go high.
What is the impact of deflation on the stock market?
Deflation could trigger the liquidity trap that’s because, during deflation, prices of goods and services go down. As a result, the cash and other liquid assets will gain more power. This makes people stop investing in shares.
Which one is more harmful, inflation and deflation?
Truth be told, inflation is quite worse than deflation. With inflation on the rise, one thing becomes quite clear, which is economy of the country is not growing. On the other hand, the prices of goods and services will also fall down due to low demand by consumers. Companies will cut short their production, and it will lead to a reduction of labor, causing layoffs. It all falls under the domino effect of deflation.
How can we control deflation?
Well, there are a number of monetary methods by which government can actually control deflation. Some of the well-known ones are quantitative easing, cutting down the tax rates, lowering the rate of interest, performing open market operations, and cutting down the bank reserve limits. But all of this cannot be done by us, and all these measures can only be done by the government of a country that is going through deflation.
How is RBI responsible for controlling inflation and deflation?
One of the key responsibilities that the RBI was given was to keep a check on inflation in India. The RBI does this by making small changes in the interest rates. Over time we have seen RBI making loans costlier by slowly increasing the lending rates and thus discouraging the practice of borrowing. With people spending less money, the pricing of goods and materials will stop rising, and inflation will be moderated. On the other hand, with deflation RBI is getting a breathing space to lower the interest rates by a few percent.
Who benefits from deflation?
The consumers are on the benefiting end of deflation for a short amount of time as the prices of the goods will go down, the purchasing power of a consumer will also increase, and it makes it possible for the consumers to save more of their money by spending less and acquiring more than before.
What is Deflation?
Deflation is a drop in consumer prices. Deflation allows customers to buy more with the same money.
What are the Causes of Deflation?
1) Decreasing aggregate demand for goods and services in an economy (i.e., a recession).
2) An increase in the supply of money reduces the purchasing power of each unit of currency.
How does deflation affect the economy?
Since deflation reduces demand for goods and services and puts pressure on businesses' profit margins, it can cause companies to lay off workers or even go out of business entirely.