UNIT-III DEFLATION

WHAT IS
DEFLATION?
• DEFLATION IS A DECREASE IN THE GENERAL PRICE LEVEL OF GOODS AND
SERVICES. PUT ANOTHER WAY, DEFLATION IS NEGATIVE INFLATION.
WHEN IT OCCURS, THE VALUE OF CURRENCY GROWS OVER TIME. THUS,
MORE GOODS AND SERVICES CAN BE PURCHASED FOR THE SAME AMOUNT
OF MONEY.
• DEFLATION IS WIDELY REGARDED AS AN ECONOMIC “PROBLEM” THAT CAN
INTENSIFY A RECESSION OR LEAD TO A DEFLATIONARY SPIRAL.
COUNTRIES WITH THE LOWEST
INFLATION RATE IN
2015
 CAUSES OF
DEFLATION
• ECONOMISTS DETERMINE THE TWO
MAJOR CAUSES OF DEFLATION IN AN
ECONOMY AS
(1) FALL IN AGGREGATE DEMAND AND
(2) INCREASE IN AGGREGATE SUPPLY.
 FALL IN THE MONEY
SUPPLY
• A CENTRAL BANK MAY USE A TIGHTER MONETARY POLICY BY
INCREASING INTEREST RATES. THUS, PEOPLE, INSTEAD OF SPENDING
THEIR MONEY IMMEDIATELY, PREFER TO SAVE MORE OF IT. IN
ADDITION,
INCREASING INTEREST RATES LEAD TO HIGHER BORROWING COSTS,
WHICH ALSO DISCOURAGES SPENDING IN THE ECONOMY.
 DECLINE IN
CONFIDENCE
• NEGATIVE EVENTS IN THE ECONOMY, SUCH AS RECESSION, MAY ALSO
CAUSE A FALL IN AGGREGATE DEMAND. FOR EXAMPLE, DURING A
RECESSION, PEOPLE CAN BECOME MORE PESSIMISTIC ABOUT THE FUTURE
OF THE ECONOMY. SUBSEQUENTLY, THEY PREFER TO INCREASE THEIR
SAVINGS AND REDUCE CURRENT SPENDING.
 LOWER PRODUCTION
COSTS
• A DECLINE IN PRICE FOR KEY PRODUCTION INPUTS (E.G., OIL) WILL LOWER
PRODUCTION COSTS. PRODUCERS WILL BE ABLE TO INCREASE PRODUCTION
OUTPUT, WHICH WILL LEAD TO AN OVERSUPPLY IN THE ECONOMY. IF
DEMAND REMAINS UNCHANGED, PRODUCERS WILL NEED TO LOWER THEIR
PRICES ON GOODS TO KEEP PEOPLE BUYING THEM
 TECHNOLOGICAL
ADVANCES
• ADVANCES IN TECHNOLOGY OR RAPID APPLICATION OF NEW
TECHNOLOGIES IN PRODUCTION CAN CAUSE AN INCREASE IN AGGREGATE
SUPPLY. TECHNOLOGICAL ADVANCES WILL ALLOW PRODUCERS TO LOWER
COSTS. THUS, THE PRICES OF PRODUCTS WILL LIKELY GO DOWN.
 EFFECTS OF
DEFLATION
• FREQUENTLY, DEFLATION OCCURS DURING RECESSIONS. IT IS CONSIDERED
AN ADVERSE ECONOMIC EVENT AND CAN CAUSE MANY NEGATIVE EFFECTS ON
THE ECONOMY, INCLUDING:
 INCREASE IN
UNEMPLOYMENT
• DURING DEFLATION, THE UNEMPLOYMENT RATE WILL RISE. SINCE PRICE
LEVELS ARE DECREASING, PRODUCERS TEND TO CUT THEIR COSTS BY
LAYING OFF THEIR EMPLOYEES.
 INCREASE IN THE REAL VALUE OF
DEBT
• DEFLATION IS ASSOCIATED WITH AN INCREASE IN INTEREST RATES,
WHICH WILL CAUSE AN INCREASE IN THE REAL VALUE OF DEBT. AS A
RESULT, CONSUMERS ARE LIKELY TO DEFER THEIR SPENDING
 THE REAL COST OF BORROWING
INCREASES

• REAL INTEREST RATES WILL RISE IF NOMINAL RATES OF INTEREST DO

NOT FALL IN LINE WITH PRICES.
 LOWER PROFIT
MARGINS
• LOWER PRICES CAN MEAN REDUCED REVENUES & PROFITS FOR BUSINESSES
- THIS CAN THEN LEAD TO HIGHER UNEMPLOYMENT AS FIRMS SEEK TO
REDUCE COSTS BY SHEDDING LABOUR.
 EXPORTERS MORE
COMPETITIVE
• DEFLATION CAN MAKE EXPORTERS MORE COMPETITIVE EVENTUALLY – BUT
THIS OFTEN COMES AT A COST I.E. HIGHER UNEMPLOYMENT IN SHORT
TERM
HOW DOES ONE COUNTERACT
AGAINST DEFLATION?

• UNTIL THE 1930S, IT WAS COMMONLY BELIEVED BY ECONOMISTS THAT

DEFLATION WOULD CURE ITSELF. •
• AS PRICES DECREASED, DEMAND WOULD NATURALLY INCREASE AND THE
ECONOMIC SYSTEM WOULD CORRECT ITSELF WITHOUT OUTSIDE
INTERVENTION.

• THIS VIEW WAS CHALLENGED IN THE 1930S DURING THE GREAT DEPRESSION
BY THE ECONOMIST KEYNES WHO ARGUED THAT THE ECONOMIC SYSTEM WAS
NOT SELF-CORRECTING WITH RESPECT TO DEFLATION.
 WHAT DID KEYNES
SAY?
• ACCORDING TO HIM, GOVERNMENTS AND CENTRAL BANKS HAD TO TAKE
ACTIVE MEASURES TO BOOST DEMAND THROUGH TAX CUTS OR INCREASES
IN GOVT. SPENDING.
• TODAY, TO COUNTER DEFLATION, THE RESERVE BANK OF INDIA (RBI) CAN
USE MONETARY POLICY TO INCREASE THE MONEY SUPPLY AND
DELIBERATELY INDUCE PRICE RISE.
• RISING PRICES PROVIDE AN ESSENTIAL LUBRICANT FOR ANY SUSTAINED
RECOVERY BECAUSE BUSINESSES INCREASE PROFITS AND THIS TAKES
SOME OF THE DEPRESSIVE PRESSURES OFF THEM.
 ECONOMIC POLICIES TO AVOID
PRICE DEFLATION

• THE MAIN APPROACH TO AVOIDING DEFLATION IS TO USE MACRO-STIMULUS POLICIES

EITHER BY LOOSENING MONETARY POLICY AND/OR FISCAL POLICY

• LOW INTEREST RATES AND QUANTITATIVE EASING

• IN SOME COUNTRIES, POLICY INTEREST RATES HAVE BECOME NEGATIVE
E.G. SWITZERLAND
• CHEAPER LOANS FOR BUSINESSES AND HOUSEHOLDS
• EXPANDING THE SUPPLY OF CREDIT IN BANKING SYSTEM
• QE USED BY MANY CENTRAL BANKS INCLUDING BOE AND EUROPEAN BANK
 FISCAL STIMULUS
MEASURES
• HIGHER GOVERNMENT SPENDING (E.G. CAPITAL PROJECTS)
• A RISE IN GOVERNMENT BORROWING TO INJECT DEMAND INTO
THE CIRCULAR FLOW
• LOWER DIRECT TAXES TO INCREASE DISPOSABLE INCOME AND
SPENDING
 OTHER MEASURES TO STIMULATE
AGGREGATE DEMAND

• ATTEMPTS TO LOWER THE VALUE OF THE EXCHANGE RATE (PERHAPS VIA

CENTRAL BANK INTERVENTION TO SELL THEIR CURRENCY IN THE MARKET)
• HIGHER TAXES ON SAVINGS TO ENCOURAGE CONSUMPTION
 STAGFLATION
•A condition of slow economic growth and relatively high unemployment
- a time of stagnation - accompanied by a rise in prices, or inflation.
• Stagflation occurs when the economy isn't growing
but prices are, which is not a good situation for a
country to be in. This happened to a great extent
during the 1970s, when world oil prices rose
dramatically, fueling sharp inflation in developed
countries. For these countries, including the U.S.,
stagnation increased the inflationary effects.
 CAUSES:
• Stagflation is an economic trend in which inflation and
unemployment rise while general growth of the economy is slow. It
can be difficult to correct this trend, because focusing on one aspect
of the problem can exacerbate other aspects.
• Many governments try to avoid stagflation through fiscal policy, by
promoting even and healthy growth and attempting to prevent
inflation. If the condition continues long enough, it will trigger an
economic recession and an ultimate self-correction.
• stagflation is so dangerous. Imagine a scenario in which you have both
a sinking economy and runaway inflation.
 REFLATION
• Reflation is an economic term referring to stimulating measures
taken to lessen or stop the effects of deflation. Reflationary
measures can consist of fiscal policy (lowering taxes) or monetary
policy (changing money supply or lowering interest rates).
• For example, the Federal Reserve may choose to lower interest rates
to jump start a weak economy common in deflationary periods.
DISINFLATION
• A slowing in the rate of price inflation. Disinflation is used to describe
instances when the inflation rate has reduced marginally over the
short term. Although it is used to describe periods of slowing
inflation, disinflation should not be confused with deflation.