Even if deflation appears to have a positive effect on household budgets for consumers, it is more dangerous for the economy than inflation. Deflation is the opposite of inflation and means a fall in prices. If there is no more price increase, one speaks of stagnation.
Deflation can become a dangerous downward spiral for an economy. To combat deflation, central banks lend cheap money to banks. These should stimulate investments by granting cheap loans, which in turn should create jobs and thereby strengthen purchasing power and increase demand.
Definition of deflation
What is deflation? When there is deflation, the prices of goods in the market fall. So, the value of money is increasing – people can buy more with their money. However, what sounds good at first has serious disadvantages. In fact, with inflation, money loses purchasing power.
Let’s understand the causes of deflation before we talk more about its serious consequences.
Causes of deflation
Deflation can occur when a central bank reduces the money supply too much as part of its monetary policy. Another reason can be that companies produce too many goods and there is an oversupply on the market.
Deflation is often favored and accelerated by reduced spending by private households and companies. In difficult economic times, people prefer to save. You don’t know if the future won’t get even worse. Companies are also cutting back on their investments.
Deflationary spiral
The monetary policy of the central banks is based on the optimization of the so-called magic square. This regulates the interaction between:
- Full employment,
- Price stability,
- Balanced foreign trade
- Steady economic growth.
It is the development and interaction of these factors that lead to deflation. When economic growth falls, the employment rate tends to fall as well. Rising unemployment leads to a drop in demand for goods. However, since companies have to sell, they are initially forced not to raise prices, which, together with rising unemployment, leads to falling wages. If demand continues to fall, stockpiles are formed. In order to reduce this, a price reduction must take place. The downward spiral has thus begun.
Consequences of deflation
Inflation results from rising demand and drives economic growth through higher production figures. During deflation, productivity falls, and there is no economic growth. Only foreign trade still offers a solution in this situation. Since prices in one economic zone drop significantly during deflation, companies may be able to deliver cheaper than their competitors in other economic zones with higher price levels.
Approaches to fighting deflation
When deflation occurs, there is a lack of demand, which usually results from high unemployment. So, the first step would be to create new jobs. These arise when companies have funds to make investments. For this purpose, the banks have to grant loans on more favorable terms.
The central banks can take the step of increasing the liquidity (free reserves) of the banks. In theory, banks can provide a credit on more favorable terms once they receive sufficient cash reserves from central banks. This gives companies the opportunity to create new jobs through investments. More jobs increase the purchasing power of the population and lead to increased domestic demand, which in turn means an increase in the production of consumer goods due to increased demand. This will stimulate economic growth again.
The banks have a key role in handling this situation since the central banks themselves are not allowed to lend to the economy. However, this cycle cannot be broken if private credit institutions remain reluctant to lend money.
Is inflation better than deflation?
Central banks consider an annual inflation rate of two percent to be healthy. A moderate price increase signals that there is a steady economic growth. Rising personnel costs, as one of the drivers of rising prices, demonstrate a certain degree of employment, which in turn means demand. Japan suffered from the effects of deflation in the 1990s, and today confirms that this was the most difficult period in the Japanese economy. The recovery period lasted longer than the period of deflation itself.
Some environmentalists talk about negative growth or deflating economies to stop climate change and carbon emissions but if people can’t afford basic necessities such as heating a deflating economy might be worse than an inflating one. Companies respond to falling prices by slowing down their production, which leads to layoffs and salary reductions.
