When an economy undergoes a deflationary shock, the implications can be both positive and negative for consumers and businesses. There is a big difference between the terms disinflation and deflation, which we will first go over before getting into the causes and effects of deflationary shocks, and how these shocks can affect the economy, consumers and businesses.
SEE: All About Inflation
Disinflation usually occurs during a period of recession and manifests itself by slowing down the rate at which prices increase; this occurs as a result of a decrease in consumer sales. If the inflation rate drops to a lower level than before, technically that difference is disinflation.
Deflation, on the other hand, can be thought of as the opposite of inflation, or as negative inflation, and it occurs when the supply of goods or services rises faster than the supply of money.
Deflation and Its Causes
Deflation manifests itself as a simultaneous sustained contraction or decline in:
- The general level of prices for goods and services that comprise the consumer basket (consumer price index)
- Business and consumer credit availability (credit/lending practices)
- Consumer demand triggered by a decline in the money supply
- Government spending
- Business investment spending
- Investment assets
The precursor or precondition of deflation can be a recessionary period (which can deteriorate to an economic depression), during which there is either an excessive extension of credit or a huge assumption of debt.
Deflation can be triggered by any combination of the following factors:
- A decline in the money supply
- An increase in the supply of goods or services, which exacerbate the situation and further lower prices
- A decrease in the demand for goods
- An increase in the demand for money
Either an increase in the demand for, or a decrease in the supply of, money will result in people wanting more money, which will result in a higher interest rate (price of money). The increased interest rates will result in decreased demand, as consumers and businesses will reduce borrowing money to make purchases.
If deflation is exacerbated, it can throw an economy into a deflationary spiral. This happens when price decreases lead to lower production levels, which, in turn, leads to lower wages, which leads to lower demand by businesses and consumers, which lead to further decreases in prices. Two sectors of the economy that have traditionally remained well-insulated from economic downturns are education and healthcare as their costs and prices may actually increase while the general level of prices for most goods and services declines.
Money Supply and Deflation
Let's examine the factors and components of deflation, the workings of each and how they impact the economy. We'll start with money supply and lending and credit availability.
The money supply is defined as the total amount of money that is available in an economy at a given time; it includes currency and the various types of deposits offered by banks and other depository institutions. Although money no longer has an intrinsic value, it does have four very valuable functions that facilitate the functioning of an economy and a society: it serves as a medium of exchange, unit of account, store of value and standard of deferred payment.
Types of Credit
Credit, and the extension of credit, is the ability of a debtor to access cash to accomplish goals of a financial or non-financial nature. Credit comes in two different forms and each form works and impacts the debtor differently.
The two types of credit are self-liquidating and the non-self-liquidating credit. Self-liquidating credit is usually a loan needed for the production of (capital) goods or provision of services, and it is for a fairly short to intermediate time period. Due to its nature, the use of such credit generates the financial returns and cash flow that enables the loan repayment and adds value to an economy. The non-self-liquidating type of credit is a loan that is used for the purchase of consumer goods (consumption); it is not tied to the production of goods or services, it relies on other sources of income or cash to be repaid and it tends to stay in the system for a long period of time as it does not generate any income or cash to liquidate itself. This type of lending and credit extension tends to be counterproductive and adds a substantial cost (including opportunity cost) instead of value to an economy, as it tends to burden production.
Lending is based on a dual principle: the willingness of the lender to extend credit and provide funds to consumers and businesses, and the ability of the borrower to repay the loan with interest at a given interest rate based on credit scores and ratings (price of money). Both principles rely on the lenders' and the consumers' confidence in each other, and a positive and upward production trend which enable the debtors to pay back their loan obligations. When that upward growth production trend slows down or stops so does confidence, which impacts the desire to lend and the ability to pay back loans.
Such conditions shift the focus of all participants in an economy from growth to conservation and survival. This translates to creditors becoming more conservative and careful on their lending practices and applications, which leads to a decline in consumer and business spending; this subsequently affects production because the demand for goods and services has declined. The decline in business and consumer spending exerts downward pressure on the prices of goods and services and leads to deflation.
Deflation's Impact on an Economy
What really happens during deflationary shocks? People increase their savings and spend less, especially if they are in fear of losing their jobs or other sources of income. The stock market experiences turbulent fluctuations and indicates a declining trend while at the same time there is a decrease in company buyouts, mergers and hostile takeovers. Governments revise or effect increasingly strict regulation legislations and implement governmental structural changes. As a result of this behavior, investment strategies will switch to less risky and more conservative investment vehicles. In addition, investment strategies will favor tangible investments (real estate, gold/precious metals, collectibles) or short-term investments that tend to maintain their values and provide the consumer with more stable purchasing power.
From a macroeconomic perspective, deflation is caused by a shift in the demand (investment and saving equilibrium) and supply (liquidity preference and money supply equilibrium) curves for final goods and services and a decline in the aggregate demand (gross domestic product), which monetary policy can impact and alter.
When the volume of money and credit transactions decline, relative to the volume of goods and services available, then the relative value of each unit of money rises, making prices of goods fall. In actuality it is the value of money itself that fluctuates and not the value of the goods that is reflected in their prices. The price effects of deflation tend to occur and cut across the board in both goods and investment assets.
From a microeconomic perspective, deflation affects two important groups: consumers and businesses.
Impact on the Consumer
These are some of the ways that consumers can preparefor deflation:
- Pay down or pay off any non self-liquidating debt such as personal loans, credit card loans etc.
- Increase the amount of savings out of each paycheck
- Maintain retirement contributions despite stock market fluctuations
- Seek out bargains and negotiate down for any durable goods that need to be acquired or replaced
- If there is a feeling of insecurity concerning job continuation and stability or income generating assets, start seeking out alternative sources of income
- Go back to school or update skills to enhance personal marketability
Impact on Business
The following are some of the ways that a business can prepare for deflation:
- Develop an action plan that will provide alternatives to any of the business aspects, sectors or costs that will be impacted by deflation
- Do careful planning on the production of goods and services and inventory reduction
- Investment planning should focus on higher value goods or services and avoid higher cost/lower value ones
- Increase investments that will boost productivity and reduce costs
- Re-evaluate all costs and contractual agreements with clients and suppliers and take appropriate action as necessary
The Bottom Line
Deflation can be beneficial if producers or suppliers can produce more goods at a lower cost, leading to lower prices for consumers. This can be due to either cost-cutting techniques or more efficient production due to improved technology. Deflation can also be perceived as beneficial because it can increase the purchasing power of the currency, which buys more goods and services.
However, deflation can also be harmful to an economy as it forces businesses to cut prices to attract consumers and stimulate the quantity demanded, which has further harmful effects. Deflation also has a harmful effect on borrowers because they must pay back loans in dollars that will buy more goods and services (higher purchasing power) than the dollars they borrowed. Consumers or businesses that procure new loans will raise the real or inflation-adjusted cost of credit, which is the exact opposite effect of what the monetary policy tries to accomplish to combat falling demand. Deflation forces a country's central bank to revalue its monetary unit and readjust its economic and regulatory policies to deal with deflationary shocks.
Not to be confused with Deflation.
Disinflation is a decrease in the rate of inflation – a slowdown in the rate of increase of the general price level of goods and services in a nation's gross domestic product over time. It is the opposite of reflation. Disinflation occurs when the increase in the “consumer price level” slows down from the previous period when the prices were rising.
If the inflation rate is not very high to start with, disinflation can lead to deflation – decreases in the general price level of goods and services. For example, if the annual inflation rate for the month of January is 5% and it is 4% in the month of February, the prices disinflated by 1% but are still increasing at a 4% annual rate. Again if the current rate is 1% and it is –2% for the following month, prices disinflated by 3% i.e. [1%–(-2)%] and are decreasing at a 2% annual rate.
There is widespread consensus among economists that inflation is caused by increases in the supply of money available for use in a nation's economy. Inflation can also occur when the economy 'overheats' because of excess aggregate demand (this is called demand-pull inflation). The causes of disinflation are the opposite, either a decrease in the growth rate of the money supply, or a business cycle contraction (recession). If the central bank of a country enacts tighter monetary policy, that is to say, the government starts selling its securities, the supply of money in an economy is reduced. This contraction of the money supply is known as quantitative tightening. During a recession, competition among businesses for customers becomes more intense, and so retailers are no longer able to pass on higher prices along to their customers. The main reason is that when the central bank adopts tight monetary policy, it becomes expensive to access money, which reduces demand for goods and services in the economy. Even though demand for commodities falls, supply of commodities remains unaltered. Thus, prices fall over time, which leads to disinflation. In contrast, deflation occurs when prices are actually dropping.
A growth rate of unemployment below the natural rate of growth leads to an increase in the rate of inflation. But a growth rate of unemployment above the natural rate of growth leads to a decrease in the rate of inflation, also known as disinflation. This happens because when people are jobless they have less money to spend, which indirectly implies a money supply reduction in an economy.
Japan an example of disinflated economy
The best example for a disinflated economy is Japan. In 1990 Japan's output growth rate was 5.2%, unemployment rate was 2.1% and inflation rate was 2.4%. But in 1992 the output growth rate fell to 1.0%, unemployment rate rose to 2.2% and inflation rate decreased to 1.7%. In the year 2000 the output growth rate was 2.8%, unemployment rate was 4.7% and inflation rate was –1.6%.
|Year||Output Growth Rate %||Unemployment Rate %||Inflation Rate %|
Disinflation distinguished from deflation
If disinflation continues until the inflation rate is zero, the economy enters a deflationary period, with decreasing general prices on all goods and services produced. An example of this happened during the month of October 2008, when U.S. consumer prices fell (deflation) by 1.01% but the overall annual inflation rate simply decreased (disinflation) from an annual rate of 4.94% to 3.66%. So the distinction between deflation and disinflation at that point was simply one of which time period was referred to—the monthly basis or the annual basis. Over the year, prices were up 3.66% while over the month prices were down 1.01%.
Disinflation is reduction in the inflation rate. Prices are still rising during disinflation, but at a lower rate. The general price level still rises, but at a slower rate resulting in a lower rate of real value destruction in money and other monetary items.
Deflation is a sustained decrease in the general price level (negative inflation rate) resulting in a sustained increase in the real value of money and other monetary items. Money and other monetary items are worth more all the time during deflation as opposed to being worth less all the time during inflation. Deflation causes an increase in the real value of money and other monetary items.
Disinflation, the Phillips curve and sacrifice ratio
The Phillips Curve shows that there is a negative relationship between inflation and unemployment.
The relationship between the Phillips curve and disinflation can be written as Өt-Өt-1=-ἀ(ut-un).
Here Өt is the present year's rate of inflation, Өt-1 is the previous year's rate of inflation, ut is the actual rate of unemployment and un is the natural rate of unemployment. ἀ is the parameter that captures the effect of unemployment on the wage. The L.H.S (left hand side) of the equation is the change in the inflation rate. The above equation explains that the change in the rate of inflation depends upon the difference between the actual rate of unemployment and the natural rate of unemployment i.e., (ut-un). The rate of inflation would decrease when the actual rate of unemployment is higher than the natural rate of unemployment leading to Disinflation. The inflation rate would increase when natural unemployment rate is higher than the actual unemployment rate.
To decrease the rate of inflation, the left side of the equation must be negative and the term (ut-un) must be positive. Mathematically:ut > un = Disinflation ut < un = High Inflation
Though a decrease in the rate of inflation and the unemployment growth rate are related to each other, the relationship does not depend on the speed of disinflation. Simply speaking, the rate of inflation can be slowed by increasing the rate of unemployment at a smaller rate spread over many years—or disinflation can be achieved quickly by increasing the rate of unemployment at a higher rate spread over a few years. When we sum the rate of unemployment over the years, it is same.
This phenomenon can be explained with the help of point-year of excess unemployment. It is the difference between the actual and the natural rate of unemployment of one percentage point for one year. For example, suppose the natural rate of unemployment is 9%; an unemployment rate of 15% for 5 years in a row corresponds to five times (15-9 = 6; 5*6 = 30) point years of excess unemployment. Suppose the central bank wants to reduce inflation from 15% to 10% so that inflation rate equals to 5% and that too within a period of 1 year. The equation Өt-Өt-1=-ἀ(ut-un). states that to reduce the inflation rate to 5% requires one year of unemployment at 10% above the natural rate. The R.H.S equals to –5% and the inflation rate decreases by 10% within a year. Following this phenomenon to reduce inflation over 5 years requires 5 years of unemployment at 1%i.e.(10/5) above the natural rate, and so on. We can note that in the above phenomenon the number of point-years of excess unemployment required to decrease inflation is the same i.e. 5%.
A cost is always involved in reducing inflation. This is explained with the help of a sacrifice ratio. The sacrifice ratio is the amount of cost required to reduce the rate of inflation over time. It is the ratio of the aggregate percentage loss of GDP to the decrease in inflation. For example, suppose the central bank wants to reduce the inflation rate from 20% to 12% over a period of 4 years. To achieve this rate, suppose the economy must bear the cost of an output level 12% below plausible in the first year, 9% below the plausible in the second year, 6% below plausible in the third year, and 5% below plausible in the fourth year. Thus the total loss of GDP is 32% (12%+9%+6%+5%) and the decrease in inflation rate is 8%. Thus the sacrifice ratio is 4 (32/8).
To reduce inflation, policymakers must choose between cold-turkey and gradualist policies. Cold-Turkey policies try to reduce the inflation rate as quickly as possible towards a target. Gradualist policies reduce the rate of inflation is reduced at a slow pace, that is to say these policies move the economy slowly towards a target. Cold-turkey policies create a shock-effect, which might not be good for the economy if the shock is great but can be good for the economy if it builds policymaker trustworthiness. New information can be incorporated if the gradualist policies are played out by the policymakers.
Credibility and cost of inflation
The Lucas critique states that it is improbable to assume that wage setters would not consider changes in policy when forming their expectation. If wage setters believe that policymakers are committed to decreasing the inflation rate, they lower their expectations of inflation, and this leads to a decline in the rate of actual inflation without the need for prolonged recession. This can be explained with the help of the above-mentioned equation, in which expected inflation is taken on the right: Өt=Өte-ἀ(ut-un). If the wage-setters look at the previous year's inflation rate and form their expectations accordingly, then inflation rate can be reduced only by accepting a higher rate of unemployment for some period. If Өte=Өt-1, from Өt-Өt-1=-ἀ(ut-un. Thus, to achieve: Өt < Өt-1, it must be that ut > un) If, however, wage-setters expect the rate of inflation to fall from 9% to 5%—i.e., it will indeed be lower than the past—then inflation would fall to 5% even if unemployment remains at the natural rate of unemployment.
One of the most important constituents of successful disinflation is the credibility of monetary policy according to Thomas J. Sargent. It states that the beliefs of wage setters are affected if they feel that the central bank are religiously committed in reducing the rate of inflation. The way the wage-setters formed their expectations can only be changed with the help of credibility. The credibility view is that fast disinflation is likely to be more credible than slow disinflation. Credibility decreases the unemployment cost of disinflation. Therefore, the central bank should go for fast disinflation.
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