Deflation is the general decline in the price level of goods and services. Deflation is often associated with a contraction in the money and credit supply, but prices may also fall due to increased productivity and technological advances.
Whether the economy, price level, and money supply are declining or inflating, changing the attractiveness of different investment options.
What is Deflation?
Deflation is a general decline in the prices of goods and services, typically associated with a contraction in the money and credit supply in the economy. During deflation, the purchasing power of the currency increases over time.
Understanding Deflation
Deflation causes the nominal costs of capital, labor, goods and services to fall even if their relative prices do not change. Deflation has been a popular concern among economists for decades. At first glance, deflation benefits consumers because they can buy more goods and services with the same nominal income over time.
Not everyone gains from lower prices, however, and economists are often concerned about the consequences of falling prices on various sectors of the economy, particularly in financial matters. In particular, deflation can harm borrowers who may have to pay off their debts with money that is worth more than the money they borrowed, as well as any financial market participant who invests or speculates on rising prices.
Causes of Deflation
By definition, monetary deflation is only the result of a decrease in the money supply or convertible financial instruments. can be caused. In modern times, the money supply is most influenced by central banks such as the Federal Reserve. When the supply of money and credit falls, without a corresponding reduction in economic output, then the prices of all goods tend to fall. Periods of deflation most commonly occur after prolonged artificial monetary expansion. Other countries, such as Japan in the 1990s, have experienced deflation in modern times.
World-renowned economist Milton Friedman argued that in an optimal policy where the central bank seeks a deflation rate equal to the real interest rate of government bonds, the nominal rate should be zero and the price level should fall steadily in the real rate. His theory gave birth to the Friedman rule, a monetary policy rule.
However, a number of other factors can cause prices to fall: fall in aggregate demand (fall in aggregate demand for goods and services) and increased productivity. A decrease in aggregate demand typically results in subsequent lower prices. Reasons for this shift include reduced government spending, stock market failure, consumer desire to increase savings, and tight monetary policies (high interest rates).
Falling prices can also naturally occur when the economy’s output grows faster than the circulating supply of money and credit. This occurs especially when technology improves the productivity of an economy and is often concentrated in goods and industries that benefit from technological advances. As technology advances, companies operate more efficiently. These operational improvements lead to lower production costs and cost savings passed on to consumers in the form of lower prices. This is different from, but similar to, general price deflation, which is a general fall in the price level and an increase in the purchasing power of money.
Price deflation through increased productivity is different in certain industries. For example, consider how increased productivity is affecting the tech industry. Over the past few decades, advances in technology have resulted in significant reductions in the average cost per gigabyte of data. The average cost of a gigabyte of data in 1980 was $437,500; Up until 2014 the average cost was three cents. This decrease has also caused the prices of manufactured products using this technology to drop significantly.
Changing Views on the Effect of Deflation
After the Great Depression, when monetary deflation coincided with high unemployment and rising defaults, most economists believed that deflation was a negative phenomenon. Later, most central banks adjusted their monetary policy to encourage consistent increases in the money supply, even if it encouraged chronic price inflation and encouraged borrowers to borrow too much.
British economist John Maynard Keynes warned against deflation as he believed it contributed to the downward cycle of economic pessimism during recessions when wealth holders saw asset prices fall, thereby reducing their investment appetite. Economist Irving Fisher developed a complete theory for economic depressions based on debt deflation. Fisher argued that the liquidation of debts after an adverse economic shock can cause a greater reduction in the supply of credit in the economy, which can lead to deflation, which in turn can create further pressure on debtors, leading to even more liquidation and turn into a crisis.
Recently, economists have increasingly challenged older interpretations of deflation, particularly after the 2004 study by Andrew Atkeson and Patrick Kehoe. After examining 17 countries over a 180-year period, Atkeson and Kehoe found that 65 of 73 periods of deflation had no economic recession, and 21 of 29 depressions had no deflation. Now there is a wide variety of opinions about the utility of deflation and price deflation.
Deflation Changes Debt & Equity Financing
Deflation makes it less economical for governments, businesses, and consumers to use debt financing. However, deflation increases the economic power of savings-based equity financing.
From an investor’s point of view, companies that have accumulated large cash reserves or have relatively little debt are more attractive under deflation. The opposite is true for highly indebted businesses with little cash assets. Deflation also encourages increased returns and increases the required risk premium on securities.
