- What is deflation?
- What are the causes of deflation?
- What are the dangers of deflation:
- What is deflation?
Deflation is a sustained fall in an aggregate measure of prices. Changes in prices in one economic sector, or falling prices over a short period of time (one or two quarters) therefore do not qualify as real deflation.
Declining prices can be driven by an increase in supply due to technological innovation and rapid productivity gains. These supply induced shocks are usually not problematic and can even be accompanied by robust growth – this is most evident within China.
A fall in prices led by a drop in demand – which is due to a severe economic cycle, tight economic policies, or a demand side shock – or by persistent excess capacity can be much more harmful, and is more likely to lead to persistent deflation.
- What are the causes of deflation?
Economics often point towards two major deflation causes: namely these are an increase in aggregate supply, or a decrease in aggregate demand. A central bank may use righter monetary policies by increasing interest rates. Instead of individuals spending their money immediately, they may prefer to save more of it. Increasing interest rates leads to higher borrowing costs, in turn discouraging spending within the economy.
Overall declines within confidence. This may also cause a fall in aggregate demand. During a recession, individuals can become more pessimistic about the future of the economy, in turn preferring to increase savings and reduce current spending.
Increases within aggregate supply is another trigger for deflation. Producers therefore will face fiercer competition, and be forced to lower process. The growth in aggregate supply is often caused by the following factors:
Declines in prices for key production inputs overall will lower production costs. Producers will be able to increase production output, therefore leading to an oversupply within the economy. If demand remains unchanged producers must lower prices on goods to keep people buying them. Technological advances: rapid application and innovation of technologies can cause an increase in aggregate supply. Technology enables the lower costs by producers, thus the price of products is likely to decrease.
- What are the dangers of deflation:
The danger with deflation is the development of a vicious circle. As prices fall, consumer postpone buying, particularly durable goods, in the expectation that they will be cheaper in the future. Producers respond to the drop in sales by cutting costs, labour costs to be specific. Furthermore, this sets off a further fall in demand. Deflation is escaped by: raising the levels of demand and encouraging the removal of excess capacity. This can be achieved through fiscal stimulus (cutting taxes), monetary easing (cutting interest rates) or by unconventional central bank operations (buying governmental bonds).
