What Is Deflation?
Deflation is a general decline in prices for goods and services, typically associated with a contraction in the supply of money and credit in the economy. During deflation, the purchasing power of currency rises over time.
Key Takeaways
- General Decline: Deflation is the general decline of the price level of goods and services.
- Economic Contraction: Often linked with a contraction in the supply of money and credit, though prices can also drop due to increased productivity and technological improvements.
- Investment Impact: The state of the economy, price levels, and money supply influences the appeal of different investment options.
Understanding Deflation
Deflation causes the nominal costs of capital, labor, goods, and services to fall, though their relative prices may be unchanged. Deflation has been a popular concern among economists for decades. On its face, deflation benefits consumers because they can purchase more goods and services with the same nominal income over time.
However, not everyone wins with lower prices. Deflation can harm borrowers who must repay their debts in money that is worth more than the money they borrowed, as well as financial market participants who invest or speculate on the prospect of rising prices.
Causes of Deflation
Monetary Deflation
Monetary deflation can be caused by a decrease in the supply of money or financial instruments redeemable in money. Traditionally, central banks, such as the Federal Reserve, influence the money supply. A significant historical example is the deflation seen in the early 1930s in the United States initiated by bank failures and a resultant fall in the money supply. Nations like Japan experienced deflation in the 1990s for similar reasons.
Technological Advancements
Deflation can also occur when the output of the economy grows faster than the supply of circulating money and credit, often due to technological advancements. This can enhance productivity, reduce production costs, and lower prices, a pattern evident in the technology sector where the cost per gigabyte of data has dramatically decreased over recent decades.
Changing Views on Deflation’s Impact
Post-Great Depression economists regarded deflation as adverse due to its linkage with high unemployment and rising defaults. British economist John Maynard Keynes argued that deflation contributed to economic pessimism and reduced investment. Meanwhile, Irving Fisher discussed debt deflation, stipulating a vicious cycle initiated by debt liquidation.
Modern observations challenge this view, such as the 2004 study by economists Andrew Atkeson and Patrick Kehoe, which suggested deflation does not always co-occur with economic downturns, leading to diverse opinions regarding its impact.
Deflation Changes Debt and Equity Financing
Deflation influences how governments, businesses, and consumers approach financing. Debt financing becomes less attractive, while savings-based equity financing gains prominence. Companies with large cash reserves or minimal debt appeal more to investors during deflationary periods, unlike highly indebted businesses with few cash holdings. Deflation also influences yields and risk premiums on securities.
Who Is Harmed by Deflation?
Debtors struggle during deflation as the value of their debt burdens remains constant even as the overall price levels drop. This situation can negatively impact individuals and economies, including nations with substantial national debt.
How Do You Get Out of Deflation?
Governments and central banks employ various strategies to combat deflation. These include expansionary policies such as lowering reserve limits for banks, purchasing treasuries, and reducing target interest rates. Other fiscal measures include increasing government expenditure and cutting taxes to encourage spending among businesses and individuals.
What Assets Do Best During Deflation?
To safeguard portfolios, investors should consider assets that perform well during deflation. Defensive hedges include high-quality bonds, companies producing essential consumer goods, and cash.
The Bottom Line
Deflation represents a decline in the prices of goods and services, effectively increasing the value of the currency. Factors contributing to deflation range from monetary contractions to productivity enhancements driven by technological advancements. Though historically viewed negatively, contemporary perspectives on deflation are more varied. Understanding the multifaceted nature of deflation can help navigate its impacts on the economy and investments.
Related Terms: Inflation, Purchasing Power, Money Supply, Monetary Policy, Aggregate Demand.
References
- Federal Reserve Bank of San Francisco. “FRBSF Economic Letter: The Risk of Deflation”.
- Federal Reserve History. “The Great Depression: 1929-1941”.
- Bank for International Settlements. “Chronic Deflation in Japan”.
- Federal Reserve Bank of San Francisco. “FRBSF Economic Letter: What is the Optimal Rate of Inflation?”
- Dell. “Data Loss: Understanding the Causes and Costs”. Page 2.
- Internal Monetary Fund (IMF). “What Is Keynesian Economics?”
- Bank for International Settlements. “BIS Working Papers No 176 Debt-deflation: Concepts and a Stylised Model”. Pages 1, 3-5.
- National Bureau of Economic Research. “Deflation and Depression: Is There an Empirical Link?”
