Deflation

by Stephan Smith on November 16, 2010

Ohhh, this is a good topic. Good ol’ deflation. Or should I say, bad deflation. Many of us out in the world don’t know just what deflation is. Are you one of them? It’s OK if you are because you’ve made it to this page. On this page you will learn what deflation is and how it differs from inflation, disinflation and hyperinflation. (Man, that’s a lot of inflation variants) Anyway, just continue to read this page and I will explain to you what deflation is.

What is Deflation?

Deflation is the complete opposite of inflation; it is the contraction or decrease of the money supply of an economy. The result of deflation is usually a decrease in overall prices of goods and services produced in an economy. There are only two reasons why prices of goods and services would decrease. Those two reasons are supply and demand. If the supply of goods and services were to increase while demand for those goods and services were to stay stagnate or decrease, then overall prices for those goods and services would fall. The same end result would occur if the inverse were to happen. Overall prices for goods and services would decrease if demand were to decrease and supply were to stay stagnate or increase. They are interchangeable for they produce the same end result, overall prices of goods and services would decrease.

At the most fundamental level, supply and demand are the driving forces behind deflation and inflation. That being the case, allow me this opportunity to explain some factors that influences supply and demand in a way that would merit deflation. If you didn’t know my position on central banks, here is it. A central bank controls basically everything about an economy. They also control all the factors that would influence supply and demand. One way central banks can influence supply and demand to merit deflation is to enact monetary policies that would decrease a country’s money supply.

Down ChartOne way to decrease the money supply of an economy is to increase the minimum reserve requirement a commercial bank must have in order to loan money. If a central bank enacts a policy like that without adding more money into the economy’s money supply, there will be less money in circulation as commercial banks would be required to keep more money in their possession. If more money is in the possession of the commercial banks, then less money will be in the hands of the citizens in society. That in turn will make money more difficult to obtain. If money becomes more difficult to obtain, the value of money will increase. Remember supply and demand. When the supply of money decreases while demand stays stagnate, the value of money will increase.

With less money in circulation, demand for goods and services will decrease because money is harder to get. If demand for goods and services decreases and supply of goods and services stays unchanged, prices will fall. If prices for overall goods and services fall over time in an economy, that economy will experience disinflation. If demand falls so greatly that supply has trouble reaching equilibrium with demand, then the economy will continue to experience disinflation until the inevitable happens, deflation. Remember what deflation is? It’s the decrease in overall prices of goods and services in an economy. On a side note, another monetary policy that a central bank could enact to decrease the money supply of an economy is called quantitative tightening.

Deflation is a Result of a Strong Currency

And a strong currency is a result of supply and demand. I’m pretty sure you understand the concept that if the supply of money decreases while the demand for money is left unchanged, then the value of money increases. The same would occur if inverted; the value of money increases if demand for money increases while supply is unchanged. If the value of money increases, then the purchasing power of money increases. That means you can buy more goods and services with less money. The severity at which the supply of money decreases or the demand for money increases would determine whether an economy experiences mild disinflation or full blown deflation.

The Reason Why Deflation Is a Bad Thing

Now that you have a grip on deflation, I want to explain why it is a bad thing. Close your eyes and imagine…well don’t close your eyes but just imagine you live in an economy where there was no inflation or deflation. Overall prices for goods and services just maintained their price now and into the future. In this scenario there would be no incentive to make purchases immediately, nor is there any incentive to postpone purchases. You could just take your time and buy when you’re good and ready with no outside influences. Now imagine the economy you lived in has an annual inflation rate of 2.5 percent. Now there is a slight incentive to make purchases as soon as possible. Why? Because the prices of the goods and services you normally buy would be increasing by 2.5 percent each year.

As I mentioned in my article about inflation, there is a benefit to the economy by having low levels of inflation. That benefit is providing a slight incentive for people to make purchases now rather than later. Consuming now boosts the economy. Now imagine the economy you lived in has an annual deflation rate of 2.5 percent. There is now an incentive for people to postpone purchasing goods and services. Why? Because those same goods and services will become cheaper in the future by 2.5 percent in a year. Deflation would do damage to the economy since people would hold off from buying and consuming goods and services. Thus, companies don’t make as many sales and lay offs may escalate.

If a 2.5 percent deflation annual rate doesn’t sound like a big deal, it is. If an economy suffered with a deflation rate of 2.5 percent for 10 years, that economy would be hurting and the employment situation would probably not be very good. Take a look at the flip side. If an economy had an annual inflation rate of 2.5 percent for ten years, it would be safe to assume that the economy would be in much better condition; possibly even prospering.



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