Is Deflation Bad? The U.S. Experience

Is Deflation Bad? The U.S. Experience

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Is Deflation Bad? The U.S. Experience

The Meaning of Deflation

Deflation is the general decline in the price of commodities. The major focus is the word “general.” Prices can decline in a particular sector due to an increase in productivity and a fall in costs. The demand for the output of the particular sector may be weak, relative to the demand for other goods and services. Since such price declines are sector-specific, and despite the discomfort they bring to producers in the affected sectors, they are not a challenge for the economy as a whole. As a result, sector-specific price declines do not constitute deflation. For deflation to occur, the price decline needs to be so widespread that broad-based indexes of prices like the consumer price index (CPI) register continuous declines. In the US, the CPI is the most commonly referenced index when evaluating inflation rates. When the index in one period is lower compared to the previous one, then it can be concluded that general prices have reduced, demonstrating that the economy is experiencing deflation. Deflation may be a result of a combination of the supply and demand for products together with the demand for money. This is especially where the supply of money reduces while that of goods goes up. Historically, when deflation has occurred, increased productivity has led to an increase in the supply of goods without the supply of money increasing. This is the case with the Great Depression from 1929-1939. And possibly in Japan in the early 1990s.

An understanding of deflation requires an in-depth examination of its causes both on the demand side. On the demand side, deflation occurs where there is growth deflation and hoarding. Growth deflation implies the enduring decrease in the real cost of goods and services due to technological progress, which is followed by aggressive price cuts, leading to an increase in aggregate demand. An oversupply of the markets results in drastic price cuts. Regarding hoarding, when people expect prices of goods and services to continue reducing, they are likely to hoard their money, waiting for a further decline. Investors and buyers hoard money since its value is increasing over time, in the hope of purchasing more products in the future. On the supply side, deflation occurs due to bank credit deflation, debt deflation, decisions on the money supply side, and credit deflation. Bank credit deflation occurs when a decrease in the bank credit supply occurs because of the failures of the bank or when banks consider private entities to be high risk. It can also occur when the central bank contracts the supply of money. Money supply-side deflation demonstrates deflation to be major because of a reduction in the velocity of money. Credit deflation occurs when the central bank initiates higher interest rates, as one of the measures of controlling inflation. In the modern day where economies are credit-based, a decline in lending means less money in circulation, which is accompanied by a sharp fall-off in demand for products. Banks intervene to halt the deflationary spiral by withholding the collection of non-performing loans. The restriction of credit, since banks lack adequate money to lend, further leads to a decline in demand.

Subject/Problem

The subject to be covered is the impact of deflation on the economy, to establish whether it is good or bad. The paper examines the opportunities, challenges, and consequences associated with deflation to establish how it impacts the economy, from the lenses of the US experience. This includes a multidimensional exploration of the economic, financial, and social implications of deflation. The study seeks to offer insights into the potential strategies and policies that can be put in place to harness the positive effects while mitigating the negative implications. The research endeavors to address gaps in understanding the dynamics of deflation and its implications for businesses, consumers, policymakers, and the entire economic landscape. It delves into the intense debate regarding the implications of deflation, which has seen researchers divided over the issue. While some consider deflation to be beneficial, others think of it as having negative implications on the economy and hence undesirable. Considering the opposing viewpoints on deflation, this research will shed light on the economic phenomena, providing a more comprehensive understanding of the issue by presenting the opposing perspectives and outlining the way forward. The paper will also outline various unanswered questions and potential areas for further research regarding the impact of deflation on the economy. These areas will form the basis for other researchers to explore them and shed more light on issues that have received little attention from academicians.

Positive Implications of Deflation

While there is a consensus that deflation is bad for the economy, economic research remains sharply divided on the issue. There are mixed reactions regarding the effect of deflation on the economy, with some arguing that it is good while others maintain that it is bad for the economy and hence should be mitigated. On the one hand, economists Bordo, Landon-Lane & Redish (2004) consider the deflationary periods in the US, Germany, and Britain in the late 19th century. The economists conclude that deflation can be more positive than negative. They established that good deflation takes place when the aggregate supply of goods exceeds aggregate demand. While negative money shocks like during