Essential Things to Know About Deflation

Deflation refers to the general decrease in the prices of goods and services, and this takes place when the inflation rate falls below zero percent. Deflation takes place naturally when the money supply of an economy is fixed.

During times Forex Broker List of deflation, the buying power of the currency and wages are higher than they otherwise would have been. This is pretty distinct but similar to price deflation, which is the general decrease in the price level.

Digging Deep into Deflation

In effect, deflation causes the nominal cost of capital, labor, goods, and services to be lower than if the money supply did not sink. While price deflation is often a side-effect of monetary deflation, this isn’t always the case.

Deflation has been a known phenomenon among economists for decades. In fact, top economist Milton Friedman argued that under optimal policy, under which the central bank attempts a rate of deflation that’s equal to the real interest rate on government bonds, the nominal rate should be zero and the price level should fall steadily at the real rate of interest. This theory paved the way for the birth of the Friedman rule.

Causes of Deflation

By definition, monetary deflation can only be caused by a decrease in the supply of money or financial instruments redeemable in money. In the modern economic times, the money supply is most influenced by central banks, like the Federal Reserve.

Deflationary times are Chart and Analysis most usually happening after long periods of artificial monetary expansion. The early part of the 1930s was the last significant deflation experienced in the United States, and the major contributor to this deflationary time was the fall in the money supply after the catastrophic bank failures.

Other nations, such as Japan, have already experienced deflation in the modern times.

Deflation is caused by a plethora of factors but is mainly attributed to two:

  • A decline in aggregate demand (which is also the leftward shift in the aggregate demand curve)
  • Increased productivity

Decline in Aggregate Demand

A decline in aggregate demand usually results in subsequent lower prices. The reasons behind this shift include lower government spending, stock market failure, consumer desire to increase savings, and tightening monetary policy (basically higher interest rates).

Productivity

Companies operate more efficiently as technology advances. These operational improvements result to lower production costs and cost savings transferred to consumers in the form of lower prices.

Price deflation through higher productivity is different for certain industries. For instance, you may consider how increased productivity can impact the technology sector. During the last few decades, improvements in technology have resulted in huge reductions in the average cost per gigabyte of data.

Changing Views on Deflation

In the aftermath of the Great Depression, which was when monetary deflation coincided with high unemployment and rising defaults, most economists believed that deflation was a very unwanted phenomenon.

Thereafter, most central banks adjusted monetary policy to promote consistent increases in the money supply, even if it promoted chronic price inflation and encouraged debtors to borrow too much.