Effects of deflation

Deflation is like a terrible storm: The damage is often intense and takes far longer to repair than the storm itself. Sadly, some nations never fully recover from the damage caused by deflation. Hong Kong, for example, has yet to fully recover from the deflationary effects that gripped the Asian economy in 2002.

Deflation may have any of the following impacts on an economy:

1. Reduced Business Revenues:- Businesses must significantly reduce the prices of their products in order to stay competitive. As they reduce their prices, their revenues start to drop. Business revenues frequently fall and recover, but deflationary cycles tend to repeat themselves multiple times.

Unfortunately, this means businesses need to increasingly cut their prices as the period of deflation continues. Although these businesses operate with improved production efficiency, their profit margins eventually drop as savings from material costs are offset by reduced revenues.

2. Wage Cutbacks and Layoffs:- When revenues start to drop, companies need to find ways to reduce their expenses to meet their bottom line. They can make these cuts by reducing wages and cutting positions. Understandably, this exacerbates the cycle of deflation, as more would-be consumers have less to spend.

3. Changes in Customer Spending:- The relationship between deflation and consumer spending is complex and often difficult to predict. When the economy undergoes a period of deflation, customers often take advantage of the substantially lower prices that result.

Initially, consumer spending may increase greatly. However, once businesses start looking for ways to bolster their bottom line, consumers who have lost their jobs or taken pay cuts must start reducing their spending as well. Of course, when they reduce their spending, the cycle of deflation worsens.

4. Reduced Stake in Investments:-When the economy goes through a series of deflation, investors tend to view cash reseves as one of their best possible investments. Investors watch their money grow simply by holding onto it.

Additionally, investors’ returns on lower-risk investments often decrease significantly as central banks attempt to fight deflation by reducing interest rates, which in turn reduces the amount of money they have available for spending.

In the meantime, many other investments may yield a negative return or become highly volatile because investors are scared and companies aren’t posting profits. As investors pull out of stocks, the stock market inevitably drops.

5. Reduced Credit:- When deflation rears its head, financial lenders quickly start to pull the plugs on many of their lending operations for a variety of reasons. First of all, as assets such as houses decline in value, customers cannot back their debt with the same collateral. In the event a borrower is unable to make their debt obligations, the lenders will be unable to recover their full investment through foreclosures or property seizures.

Also, lenders realize the financial position of borrowers is more likely to change as employers start cutting their workforce. Central banks might try to reduce interest rates to encourage customers to borrow and spend more, but many customers still won’t be eligible for loans.


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