Deflation
refers to a decrease in the general price level of the economy. A fall in
prices in particular markets, such as housing, share prices or the market for
electronic goods or textiles is not the same as economy-wide deflation.
Most
economists believe that disinflation or falling inflation is beneficial for
the economy. A stable price level can lead to better decisions and a more
efficient use of scarce resources. Lower inflation also helps to stabilize
inflationary expectations. A decline in prices after an improvement in
productivity is allows companies to cut costs and prices, thereby raising
living standards.
The type of
deflation that analysts fear is the kind that is broadly-based throughout the
economy, long-lasting, and symptomatic of a weak economy stuck in recession.
When prices are falling , consumers may decide to postpone purchases in the
expectation of buying the item at a cheaper price later on. This causes a
fall in demand and can create further price declines.
Deflation
also causes real interest rates to rise, curbing demand. As well, falling
asset prices (including housing and equities) reduce personal sector wealth
and inflate the real value of debt, resulting in higher business failures and
personal bankruptcies. It is clear therefore that deflation in the economy
brings risks as well as opportunities. This is something that a government
and the monetary authorities (i.e. the Central Bank) might be concerned to
avoid.
DEFLATION
AND ECONOMIC POLICY
Deflation
can normally be controlled by an expansionary monetary policy with the
Central Bank or the Government allowing the money supply to expand. This
causes interest rates to fall and stimulates consumer spending and investment
demand. Occasionally though, when prices are falling, lenders may call in
loans or refuse to lend out to potential borrowers. This is known as a credit
crunch.
Cutting
interest rates may not be sufficient during a credit crunch. In this case,
expansionary fiscal policy (lower direct and indirect taxes and higher
government spending) is often prescribed to cure deflation. One reason
deflation is difficult to cure is that nominal interest rates cannot fall
below zero, while prices of goods and services can fall for a long time. In
this event, monetary policy is unable to prevent higher real interest rates
and the economy spirals downwards towards a slump caused by falling prices,
contracting output, falling investment, plant closures and increasing levels
of job losses in those industries affected.
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