Deflation Explained !
What Is Deflation?
Deflation is defined as an ongoing decrease in the price of commodities. A temporary decrease in prices is NOT deflation. I.E Deflation is negative inflation! This therefore means that ‘cash in hand’ as a commodity is more valuable, as you can now buy more with the same amount of money.
Unemployment
The reason periods of deflation are associated with wage reductions, and unemployment is because a consistent wage now in ‘real’ terms costs more for an employer to pay. Paying less or sacking people is the only way to maintain your real money costs. This is especially true if your employer is in a sector around which the period of deflation is based. If your prices are decreasing, and people simply are not buying then you essentially have higher costs but less money coming in!
The Finite Loop
Deflation occurs when a buying pattern emerges as such: Less demand for a product means that prices decrease. This inhibits consumer spending on the basis of the possibility of further decrease.
Less investment is made in development, and marketing of such a product, leading to even lower prices, based on further reduced demand. The circle continues.
Good or Bad?
Deflation is for the most part considered a bad thing. This is because in relation to debt, money is now more valuable, as you can buy more with it. In terms of purchasing power a debt with a certain interest rate is amplified by deflation, as that same cash amount repayment can buy more as prices of other commodities decrease.
Getting a Loan?
As far as taking out loans, less money means less lending. Demand falls further, prices continue to drop, and the assets which lenders own are now worth less. Businesses get liquidated, banks don’t have the funds to lend, and thus lending stops. This further influences the circle.
Looking bright
On the other hand if you hold large amounts of liquid assets, or cash, you have essentially profited from an economic phenomenon.
The flipside
Unfortunately however, most people have their money ‘invested’ per se in assets such as homes, cars, land, and other illiquid assets. Thus when deflation causes decreases in costs, not only is it difficult to sell such assets, but if you do you will fetch significantly less.
Making Money
Deflation can occur when money is being produced at un-proportionate rates relative to population increase. If there are more people, but the same amount of money then money is less ‘available’: it is more valuable.
Interest Rate Cuts
Deflation is the reason for interest rate cuts. For example the interest rate cuts during the 2009 recession by the ‘Bank of England’. This is done such that the increased value of your money is offset by a decreased ‘on paper’ cost.
Examples
Examples of Deflation in action are:
- The Industrial Revolution, whereby in simple terms, an increase in productivity, and production efficiency meant that the cost of producing goods was severely reduced, yet Federal Reserve DECREASED the money supply?!
The Future
If you feel a period of severe deflation coming on, then the best advice would be to keep your money under your bed! Watch out though, it could go the other way.
Remedies
To counteract deflation, government spending should be increased, and tax decreased. In 2009 the British government reduced Value Added Tax (VAT) to 15%, the intention being that this would stimulate consumer spending.
Did it work? Debatable… Has it helped? We will have to wait and see.