Deflation is a persistent fall in some generally followed aggregate indicator of price movements, such as the consumer price index or the GDP deflator. Generally, a one-time fall in the price level does not constitute a deflation. Instead, one has to see continuously falling prices for well over a year before concluding that the economy suffers from deflation. How long the fall has to continue before the public and policy makers conclude that the phenomenon is reflected in expectations of future price developments is open to question. For example, in Japan, which has the distinction of experiencing the longest post World War II period of deflation, it took several years for deflationary expectations to emerge.

In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the annual inflation rate falls below 0% - a negative inflation rate [1]. This should not be confused with disinflation, a slow-down in the inflation rate. Inflation reduces the real value of money over time; conversely, deflation increases the real value of money - the currency of a national or regional economy. This allows one to buy more goods with the same amount of money over time.

Most observers tend to focus on changes in consumer or producer prices since, as far as monetary policy is concerned, central banks are responsible for ensuring some form of price stability, usually defined as inflation rates of +3% or less in much of the industrial world. However, sustained decreases in asset prices, such as for stock market shares or housing, can also pose serious economic problems since, other things equal, such outcomes imply lower wealth and, in turn, reduced consumption spending. While the connection between goods price and asset price inflation or deflation remains a contentious one in the economics profession, policy makers are undoubtedly worried about the existence of a link [2].

2. Causes and corresponding types of deflation

In the Investment and Saving equilibrium and Money Supply equilibrium model, deflation is caused by a shift in the supply-and-demand curve for goods and services, particularly a fall in the aggregate level of demand. That is, there is a fall in how much the whole economy is willing to buy and the going price for goods. Because the price of goods is falling, consumers have an incentive to delay purchases and consumption until prices fall further, which in turn reduces overall economic activity. Since these idles the productive capacity, investment also falls, leading to further reductions in aggregate demand. This is the deflationary spiral. An answer to falling aggregate demand is stimulus, either from the central bank, by expanding the money supply, or by the fiscal authority to increase demand, and to borrow at interest rates which are below those available to private entities.

In more recent economic thinking, deflation is related to risk: where the risk-adjusted return on assets drops to negative, investors and buyers will hoard currency rather than invest it, even in the most solid of securities [5]. This can produce a liquidity trap. A central bank cannot, normally, charge negative interest for money, and even charging zero interest often produces less simulative effect than slightly higher rates of interest. In a closed economy, this is because charging zero interest also means having zero return on government securities, or even negative return on short maturities. In an open economy it creates a carry trade, and devalues the currency. A devalued currency produced higher prices for imports without necessarily stimulating exports to a like degree.

In monetarist theory, deflation must be associated with either a reduction in the money supply, a reduction in the velocity of money or an increase in the number of transactions. But any of these may occur separately without deflation. It may be attributed to a dramatic contraction of the money supply, or to adhere to a gold standard or other external monetary base requirement.

However, deflation is the natural condition of hard currency economies when the supply of money is not increased as much as positive population growth and economic growth. When this happens, the available amount of hard currency per person falls, in effect making money scarcer; and consequently, the purchasing power of each unit of currency increases. Deflation occurs when improvements in production efficiency lower the overall price of goods competition in the marketplace often prompts those producers to apply at least some portion of these cost savings into reducing the asking price for their goods. When this happens, consumers pay less for those goods; and consequently deflation has occurred, since purchasing power has increased.

Rising productivity and reduced transportation cost created structural deflation during the peak productivity era of from 1870-1900, but there was mild inflation for about a decade before the establishment of the Federal Reserve in 1913. There was inflation during World War I, but deflation returned again after that war and during the 1930s depression. Most nations abandoned the gold standard in the 1930s. There is less reason to expect deflation, aside from the collapse of speculative asset classes, under a fiat monetary system with low productivity growth.

In mainstream economics, deflation may be caused by a combination of the supply and demand for goods and the supply and demand for money, specifically the supply of money going down and the supply of goods going up. Historic episodes of deflation have often been associated with the supply of goods going up without an increase in the supply of money, or the demand for goods going down combined with a decrease in the money supply. Studies of the Great Depression by Ben Bernanke have indicated that, in response to decreased demand, the Federal Reserve of the time decreased the money supply, hence contributing to deflation.

Demand-side causes are:

Growth deflation: an enduring decrease in the real cost of goods and services resulting in competitive price cuts.

A structural deflation existed from 1870s until the end of the gold standard in the 1930s based on a decrease in the production and distribution costs of goods. It resulted in competitive price cuts when markets were oversupplied. By contrast, under a fiat monetary system, there was high productivity growth from the end of World War II until the 1960s, but no deflation [6].

Productivity and deflation are discussed in a 1940 study by the Brookings Institution that gives productivity by major US industries from 1919 to 1939, along with real and nominal wages. Persistent deflation was clearly understood as being the result of the enormous gains in productivity of the period [7]. By the late 1920s, most goods were over supplied, which contributed to high unemployment during the Great Depression [8].

Cash building deflation: attempts to save more cash by a reduction in consumption leading to a decrease in velocity of money.

Supply-side causes are:

Bank credit deflation: a decrease in the bank credit supply due to bank failures or increased perceived risk of defaults by private entities or a contraction of the money supply by the central bank.

2.1 Money supply side deflation

From a monetarist perspective, deflation is caused primarily by a reduction in the velocity of money or the amount of money supply per person.

A historical analysis of money velocity and monetary base shows an inverse correlation: for a given percentage decrease in the monetary base the result is nearly equal percentage increase in money velocity [10]. This is to be expected because monetary base (MB), velocity of base money (VB), price level (P) and real output (Y) are related by definition: MB*VB = P*Y. However, it is important to note that the monetary base is a much narrower definition of money than M2 money supply. Additionally, the velocity of the monetary base is interest rate sensitive, the highest velocity being at the highest interest rates [10].

Changes in money supply have historically taken a long time to show up in the price level, with a rule of thumb lag of at least 18 months. Bonds, equities and commodities have been suggested as reservoirs for buffering changes in money supply [13].

2.2 Credit deflation

In modern credit-based economies, a deflationary spiral may be caused by the central bank initiating higher interest rates, thereby possibly popping an asset bubble. In a credit-based economy, a fall in money supply leads to markedly less lending, with a further sharp fall in money supply, and a consequent sharp fall-off in demand for goods. The fall in demand causes a fall in prices as a supply glut develops. This becomes a deflationary spiral when prices fall below the costs of financing production. Businesses, unable to make enough profit no matter how low they set prices, are then liquidated. Banks get assets which have fallen dramatically in value since their mortgage loan was made, and if they sell those assets, they further glut supply, which only exacerbates the situation. To slow or halt the deflationary spiral, banks will often withhold collecting on non-performing loans. This is often no more than a stop-gap measure, because they must then restrict credit, since they do not have money to lend, which further reduces demand, and so on.

2.3 Scarcity of official money

When structural deflation appeared in the years following 1870, a common explanation given by various government inquiry committees was a scarcity of gold and silver; although they usually mentioned the changes in industry and trade we now call productivity. However, David A. Wells (1890) wells notes that the U. S. money supply during the period 1879-1889 actually rose 60%, the increase being in gold and silver, which rose against the percentage of national bank and legal tender notes. Furthermore, Wells argued that the deflation only lowered the cost of goods that benefited from recent improved methods of manufacturing and transportation. Goods produced by craftsmen did not decrease in price, nor did many services, and the cost of labor actually increased. Also, deflation did not occur in countries that did not have modern manufacturing, transportation and communications [14].

In economies with an unstable currency, barter and other alternate currency arrangements such as dollarization are common, and therefore when the 'official' money becomes scarce, commerce can still continue (e.g., most recently in Zimbabwe). Since in such economies the central government is often unable, even if it were willing, to adequately control the internal economy, there is no pressing need for individuals to acquire official currency except to pay for imported goods. In effect, barter acts as protective tariff in such economies, encouraging local consumption of local production. It also acts as a spur to mining and exploration, because one easy way to make money in such an economy is to dig it out of the ground.

3. Effects of deflation

The effects of deflation are:

Decreasing nominal prices for goods and services

Increasing real value of cash money and all monetary items

Discourages bank savings and decreases investment

Enriches creditors at the expenses of debtors

Benefits fixed-income earners

Recessions and unemployment

Deflation is generally regarded negatively, as it causes a transfer of wealth from borrowers and holders of illiquid assets, to the benefit of savers and of holders of liquid assets and currency. In this sense it is the opposite of inflation, which is similar to taxing currency holders and lenders and using the proceeds to subsidize borrowers. Thus inflation may encourage short term consumption. In modern economies, deflation is usually caused by a drop in aggregate demand, and is associated with recession and more rarely long term economic depressions.

While an increase in the purchasing power of one's money sounds beneficial, it amplifies the sting of debt. This is because after some period of significant deflation, the payments one is making in the service of a debt represent a larger amount of purchasing power than they did when the debt was first incurred. Consequently, deflation can be thought of as a phantom amplification of a loan's interest rate. If, as during the Great Depression in the United States, deflation averages 10% per year, even a 0% loan is unattractive as it must be repaid with money worth 10% more each year. Under normal conditions, the Fed and most other central banks implement policy by setting a target for a short-term interest rate - the overnight federal funds rate in the US - and enforcing that target by buying and selling securities in open capital markets. When the short-term interest rate hits zero, the central bank can no longer ease policy by lowering its usual interest-rate target.

In recent times, as loan terms have grown in length and loan financing is common among many types of investments, the costs of deflation to borrowers have grown larger. Deflation discourages investment and spending, because there is no reason to risk on future profits when the expectation of profits may be negative and the expectation of future prices is lower. Consequently deflation generally leads to, or is associated with a collapse in aggregate demand. Without the "hidden risk of inflation", it may become more prudent just to hold on to money, and not to spend or invest it.

Hard money advocates argue that if there were no "rigidities" in an economy, then deflation should be a welcome effect, as the lowering of prices would allow more of the economy's effort to be moved to other areas of activity, thus increasing the total output of the economy.

Deflation has effects on two main levels: on the corporate and on the governmental level.

The most obvious is on the level of companies. By definition, in the event of a deflation, Companies not only cannot raise, but have to actually decrease their prices for their products and services. If they hadn’t decreased their prices, they would go out of business. Although in a deflationary environment, most likely their production costs also decrease, most majority of companies’ profit decrease also, and after a few years they are going to annual losses (there may be companies in sectors with low competition and high profitability ratios, such as utilities, and also companies that have a large portion of profits coming from either foreign operations or from exports). In such scenarios companies cannot plan for and invest in its future growth and development.

When governments want to maintain or increase the real value of their tax income in a deflationary economy, one of three options: increase the tax base, increase tax rates, or a combination of the above two.

Tax base is the number of people and companies that pay taxes. Due to the consumption and corporate environment governments have to be very careful with broadening the tax base, but especially cautious with increasing taxes, as it may cause the economy to sink more deeply into a recession (deflationary economies are also shrinking ones).

Some wages: as companies cannot afford to increase wages, the nominal value of those wages stays the same (however, their real value increases) not only for the period of deflation, but also for some time during the following stagflation and inflationary period.

Deflationary economies have many indirect socio-, political-, financial-, and economical effects:

Rising unemployment: as companies need to cut cost, they need to fire employees, which are not producing (because they don’t have any work to do).

Higher government deficits: as most costs stay the same (for political reasons), and some expenditures increase (e.g.: rising unemployment aid payments cost of jumpstarting the economy).

Recession: no price increase; no economic growth.

More expensive imports: same foreign currency is worth more domestic currency.

More income from exports: same foreign currency income is worth more in domestic currency.

4. Alternative causes and effects

4.1 The Austrian school of economics

The Austrian school defines deflation and inflation solely in relation to the money supply. Deflation is therefore defined to be a contraction of the money supply. Only a decrease in money supply can cause a general fall in prices.

Increased productivity, however, can appear to cause deflation; but it is not general deflation; as the price of produced goods falls, while labor rates remain constant. Austrians show this as a benefit of sound money, which increases or decreases very little in total supply. Prices should simply confer the exchange ratio between any two goods in an economy. Increased productivity generally means less labor for more goods, whereas increased money supply should mean the same amount of labor for the same amount of goods.

For instance if there is a fixed money supply of 400 kg of gold in an economy that produces 200 widgets, then one widget will cost 2 kg of gold. However, next year if output is 400 widgets with the same money supply of 400 kg of gold the price of each widget will drop to 1 kg of gold. In this case the general fall in price was caused by increased productivity.

The opposite of the above scenario has the same effect on prices, but a different cause. If there is a fixed money supply of 400 kg of gold in an economy that produces 200 widgets, then once again each widget will cost 2 kg of gold. However, if next year the money supply is cut in half to 200 kg of gold with the same output of 200 widgets, the price of each widget will now only be 1 kg of gold. When capital profits are dropping rapidly, there is no reason to invest gold, which breaks the savings identity, and thus the automatic tendency of the economy to move back to equilibrium.

Austrians view increased productivity to be a good cause of a general fall in prices, while credit/money supply contraction as being a bad cause of a general fall in prices. Austrians also take the position that there are no negative distortions in the economy due to a general fall in prices in the first scenario. However, in the second scenario where a general fall in prices is caused by deflation, Austrians contend that this confers no benefit to society. For in this scenario wages will simply be cut in half and lower prices will not reflect a general increase in wealth.

Also, Austrians believe that some entity being able to inflate or deflate a money supply is given a privilege, as all prices will not change both simultaneously and proportionally. Rather price changes will occur as a response to what seems to be changes in demand, although this is only in nominal terms. Those who can inflate or deflate the money supply (or those closest to this source) can take advantage of an otherwise unknown change in the money supply by making exchanges that appear sound in nominal terms, but actually confer more profitable exchange rates in real terms, once prices have adjusted to the change.

For example, if a widget costs 5g of gold today and there is 20g of gold in the money supply, if the central bank decreases the money supply to 10g, it can sell its widgets for the formerly agreed upon price. Once the market finds less overall demand, however, prices will halve. While the central banks' money supply deflation was the cause of the price decrease, it received double the money for its widgets that they are now worth in real terms.

4.2 Keynesian economics

Keynesians insist on the distinction between consuming goods and producing goods, and between government based and credit based money supply.

For a given money supply, if wages rise faster than productivity, profits will fall and with them the price of producing goods (deflation), while consuming goods will rise (inflation). This happens in times when labor supply is tight and bargaining power is strong. When wages rise slower than productivity, profits rise as do the prices of assets relative to consuming goods. This can occur when labor supply is great and bargaining power is weak.

Inflation and deflation occur when the economic policies allow wages to increase or decrease at differing rates than productivity. Wages rising faster than productivity lead to inflation. Wages failing to increase at the rate of productivity for protracted periods will ultimately cause deflation.

Indeed, if growth continues despite lagging wages, it is because of debt accumulation, producers lend to wage earning consumers part of their profits, in order to sell their products. For protracted periods, there is a lot of endogenous money creation.

Then, when debt payments exceed the borrower's ability to pay, debt accumulation and endogenous money creation stops, demand and goods' prices fall, manufacturers reduce production, employment falls, and fewer borrowers are thus able to pay their debts, and the cycle exacerbates.

Once preventive action has failed, Keynesians advocate corrective action. In case of debt deflation, Keynesians advocate "pump priming" or government creation of fiat money. As witnessed since 1990 in Japan, and in the 1930s in the USA, this policy is not very effective unless government creates employment via public works projects or military manufacturing.

Austrians and Keynesians agree on the idea that there are counterproductive cycles of booms and bust but while the former believe the government tends to be a cause of those cycles, the latter believe it is a means to reduce the size of those cycles.

5. Historical examples

5.1 In Ireland

In February 2009, Ireland's Central Statistics Office announced that during January 2009, the country experienced deflation, with prices falling by 0.1% from the same time in 2008. This is the first time deflation has hit the Irish economy since 1960. Overall consumer prices decreased by 1.7% in the month.

Brian Lenihan, Ireland's Minister for Finance, mentioned deflation in an interview with RTÉ Radio. According to RTÉ's account, "Minister for Finance Brian Lenihan has said that deflation must be taken into account when Budget cuts in child benefit, public sector pay and professional fees are being considered. Mr Lenihan said month-on-month there has been a 6.6% decline in the cost of living this year" [9].

This interview is notable in that the deflation referred to is not discernibly regarded negatively by the Minister in the interview. The Minister mentions the deflation as an item of data helpful to the arguments for a cut in certain benefits. The alleged economic harm caused by deflation is not alluded to or mentioned by this member of government. This is a notable example of deflation in the modern era being discussed by a senior financial Minister without any mention of how it might be avoided, or whether it should be.

5.2 In Japan

Deflation started in the early 1990s. The Bank of Japan and the government tried to eliminate it by reducing interest rates, but this was unsuccessful for over a decade. In July 2006, the zero-rate policy was ended.

Systemic reasons for deflation in Japan can be said to include:

Unfavorable demographics. Japan has an aging population: 22.6% over age 65 that is not growing and will soon start a long decline. The Japanese death rate recently exceeded the birth rate [6].

Fallen asset prices. In the case of Japan asset price deflation was a mean reversion or correction back to the price level that prevailed before the asset bubble. There was a rather large price bubble in equities and especially real estate in Japan in the 1980s [20].

Insolvent companies: Banks lent to companies and individuals that invested in real estate. When real estate values dropped, these loans could not be paid. The banks could try to collect on the collateral (land), but this wouldn't pay off the loan. Banks delayed that decision, hoping asset prices would improve. These delays were allowed by national banking regulators. Some banks made even more loans to these companies that are used to service the debt they already had. This continuing process is known as maintaining an "unrealized loss", and until the assets are completely revalued and/or sold off, it will continue to be a deflationary force in the economy. Improving bankruptcy law, land transfer law, and tax law have been suggested (by The Economist) as methods to speed this process and thus end the deflation.

Insolvent banks: Banks with a larger percentage of their loans which are "non-performing", that is to say, they are not receiving payments on them, but have not yet written them off, cannot lend more money; they must increase their cash reserves to cover the bad loans.

Fear of insolvent banks: Japanese people are afraid that banks will collapse so they prefer to buy Treasury bonds instead of saving their money in a bank account. This likewise means the money is not available for lending and therefore economic growth. This means that the savings rate depresses consumption, but does not appear in the economy in an efficient form to spur new investment. People also save by owning real estate, further slowing growth, since it inflates land prices.

Imported deflation: Japan imports Chinese and other countries' inexpensive consumable goods (due to lower wages and fast growth in those countries) and inexpensive raw materials, many of which reached all time real price minimums in the early 2000s. Thus, prices of imported products are decreasing. Domestic producers must match these prices in order to remain competitive. This decreases prices for many things in the economy, and thus is deflationary.

In November 2009 Japan has returned to deflation, according to the Wall Street Journal. Bloomberg L.P. reports that consumer prices fell in October 2009 by a near record 2.2% [20].

4.3 In the United States

There have been three significant periods of deflation in the United States.

The first was the recession of the late 1830s, following the Panic of 1837, when the currency in the United States contracted by about 30%, a contraction which is only matched by the Great Depression. This "deflation" satisfies both definitions, that of a decrease in prices and a decrease in the available quantity of money.

The second was after the Civil War, sometimes called The Great Deflation. It was possibly spurred by return to a gold standard, retiring paper money printed during the Civil War.

"The Great Sag of 1873-96 could be near the top of the list. Its scope was global. It featured cost-cutting and productivity-enhancing technologies. It flummoxed the experts with its persistence, and it resisted attempts by politicians to understand it, let alone reverse it. It delivered a generation’s worth of rising bond prices, as well as the usual losses to unwary creditors via defaults and early calls. Between 1875 and 1896, according to Milton Friedman, prices fell in the United States by 1.7% a year, and in Britain by 0.8% a year [18].

The third was between 1930-1933 when the rate of deflation was approximately 10 percent; part of the United States' slide into the Great Depression, where banks failed and unemployment peaked at 25%.

The deflation of the Great Depression, as in 1836, did not begin because of any sudden rise or surplus in output. It occurred because there was an enormous contraction of credit (money), bankruptcies creating an environment where cash was in frantic demand, and the Federal Reserve did not adequately accommodate that demand, so banks toppled one-by-one. From the standpoint of the Fisher equation, there was a concomitant drop both in money supply and the velocity of money which was so profound that price deflation took hold despite the increases in money supply spurred by the Federal Reserve.

Throughout the history of the United States, inflation has approached zero and dipped below for short periods of time (negative inflation is deflation). This was quite common in the 19th century and in the 20th century before World War II.

Some economists believe the United States may be currently experiencing deflation as part of the financial crisis of 2007-2010; compare the theory of debt-deflation. Year-on-year, consumer prices dropped for six months in a row to end-August 2009, largely due to a steep decline in energy prices.

Consumer prices dropped 1 percent in October, 2008. This was the largest one-month fall in prices in the US since at least 1947. That record was again broken in November, 2008 with a 1.7% decline. In response, the Federal Reserve decided to continue cutting interest rates, down to a near-zero range as of December 16, 2008 [18]. In late 2008 and early 2009, some economists feared the US could enter a deflationary spiral. Economist Nouriel Roubini predicted that the United States would enter a deflationary recession, and coined the term "stag-deflation" to describe it [19]. It is the opposite of stagflation, which was the main fear during the spring and summer of 2008. The United States then began experiencing measurable deflation, steadily decreasing from the first measured deflation of - 0.38% in March, to July's deflation rate of - 2.10%. On the wage front, in October 2009 the state of Colorado announced that its state minimum wage, which is indexed to inflation, is set to be cut, which would be the first time a state has cut its minimum wage since 1938 [19].

6. Conclusion

Whereas policy makers today speak of the need to avoid deflation their assessment is colored by the experience of the bad deflation of the 1930s, and its spread internationally, and the ongoing deflation in Japan. Hence, not only do policy makers worry about deflation proper they also worry about its spread on a global scale.

If ideology can blind policymakers to introducing necessary reforms then the second lesson from history is that, once entrenched, expectations of deflation may be difficult to reverse. The occasional fall in aggregate prices is unlikely to significantly affect longer-term expectations of inflation. This is especially true if the monetary authority is independent from political control, and if the central bank is required to meet some kind of inflation objective. Indeed, many analysts have repeatedly suggested the need to introduce an inflation target for Japan. While the Japanese have responded by stating that inflation targeting alone is incapable of helping the economy escape from deflation, the Bank of Japan's stubborn refusal to adopt such a monetary policy strategy signals an unwillingness to commit to a different monetary policy strategy. Hence, expectations are even more unlikely to be influenced by other policies ostensibly meant to reverse the course of Japanese prices. The Federal Reserve, of course, does not have a formal inflation target but has repeatedly stated that its policies are meant to control inflation within a 0-3% band. Whether formal versus informal inflation targets represent substantially different monetary policy strategies continues to be debated, though the growing popularity of this type of monetary policy strategy suggests that it greatly assists in anchoring expectations of inflation.

7. References

1. Borio, Claudio, and Andrew Filardo. "Back to the Future? Assessing the Deflation Record." Bank for International Settlements, March 2004.

2. Burdekin, Richard C.K., and Pierre L. Siklos. "Fears of Deflation and Policy Responses Then and Now." In Deflation: Current and Historical Perspectives, edited by Richard C.K. Burdekin and Pierre L. Siklos. New York: Cambridge: Cambridge University Press, 2004.

3. Brezina Corona. How Deflation Works? Rosen Young Adult, 2007.225p.

4. Capie, Forrest, and Geoffrey Wood. "Price Change, Financial Stability, and the British Economy, 1870-1939." In Deflation: Current and Historical Perspectives, edited by Richard C.K. Burdekin and Pierre L. Siklos. New York: Cambridge: Cambridge University Press, 2004.

5. Charles Stanton Devas. Political Economy. LLC, 2009.310p.

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