What is deflation?
TYPES OF DEFLATION
Deflation can be categorized into two types, strategic and circulation deflation. Here is the explanation of each type of deflation:
Strategic deflation
This type of deflation can occur due to the establishment of monetary policy by the government related to controlling the symptoms of consumption that is considered excessive in the community. Where the occurrence of excessive consumption can suppress the increase of the product price in the market. This policy does not suppress the excessive consumption among the public, but it impacts on the price decline that will make the consumption increase in the public.
Strategic deflation is caused by policies implemented by the government and central banks to reduce the interest rates. This policy will make it easy for consumers to get a number of loans from the bank. In addition, manufacturers will keep the money they have in the bank to get a large amount of interest. This will certainly make the money circulation and the price of goods decrease.
Circulation deflation
This type of deflation arises because of the unstable economic conditions of a country. Circulation deflation occurs when the transition period of a stable economy is experiencing a slump. Situations like this will certainly make the public worried.
Circulation deflation begins from a significant decrease in people’s needs for economic goods. In addition, there is also the production of the same types of goods in similar quantities that are said to be excessive. Later on, this may cause a drastic decrease in goods prices
CAUSES OF DEFLATION
Deflation can be caused by a number of factors, all of which stem from a shift in the supply-demand curve. The price levels of all goods and services are heavily affected by a change in supply and demand. If demand drops in relation to supply, aggregate demand declines and prices fall accordingly.Likewise, a change in the aggregate demand of a national or single-market currency (such as the U.S. dollar or the euro) plays an instrumental role in setting the prices of the country’s goods and services.
Although there are many reasons why deflation may take place, the following causes seem to play the largest roles:
1. Change in Capital Market Structures:- When many different companies are selling the same goods or services, they typically lower their prices as a means to compete. Often, the capital structure of the economy changes and companies have easier access to debt and equity markets, which they can use to fund new businesses or improve productivity.
There are multiple reasons why companies might have an easier time raising capital, such as declining interest rates, changing banking policies, or a change in investors’ aversion to risk. However, after they’ve used this new capital to increase productivity, businesses have to reduce their prices to reflect the increased supply of products, which can result in deflation.
2. Increased Productivity:- Innovative solutions and new processes help increase efficiency, which ultimately leads to lower prices. Although some innovations only affect the productivity of certain industries, others may have a profound effect on the entire economy.
For example, after the Soviet Union collapsed in 1991, many of the countries that formed as a result struggled to get back on track. In order to make a living, many citizens were willing to work for very low prices, and as U.S. companies outsourced work to these countries, they were able to significantly reduce their operating expenses and bolster productivity.
Inevitably, this increased the supply of goods while decreasing their cost, which led to a period of deflation near the end of the 20th century.
3. Decrease in Currency Supply:- Currency supplies generally decrease due to actions taken by central banks, often with the explicit aim of tamping down inflation. For instance, when the Federal Reserve was first created, it considerably contracted the U.S. money supply. Unfortunately, it’s easy for currency supply reductions to spiral out of control. For example, the Fed’s early moves caused severe deflation during the early 1910s.
Likewise, spending on credit is a fact of life in the modern economy. When creditors pull the plug on lending money, consumers and businesses spend less, forcing sellers to lower their prices to regain sales. This is why one of the Federal Reserve’s top priorities today is ensuring the smooth functioning of credit markets.
4. Austerity Measures:- Deflation can be the result of decreased governmental, business, or consumer spending, which means government spending cuts can lead to periods of significant deflation. For example, when Spain initiated austerity measures in 2010, preexisting deflation began to spiral out of control in that country.
To date, Spain and other “peripheral” European economies badly affected by the sovereign debt crisis of the early 2010s contend with stagnant prices, high unemployment, and persistently slow economic growth.
5. Deflationary Spiral (Persistent Deflation):- Once deflation rears its ugly head, it can be very difficult to get the economy under control. While the actual mechanics of persistent deflation are complicated, the crux is that true deflation is self-reinforcing.
When consumers and businesses cut spending, business profits decrease, forcing them to reduce wages and cut back on investment. This short-circuits spending in other sectors, as other businesses and wage-earners have less money to spend.
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