Deflation: what is it – Dictionary of Economics

Definition of deflation

Deflation is the opposite of inflation and consists of a generalized and prolonged fall (at least two semesters according to the IMF) in the price level of goods and services.

In general, deflation is caused by the decrease in demand, which represents a much more serious problem than inflation, since a fall in demand means a general fall in the economy.

With deflation a vicious circle is created whereby when demand falls, companies see their profits reduced by having to reduce prices to achieve sales. As a consequence, they have to cut costs, which means they have to cut employees. In turn, if there are people who become unemployed, demand will continue to decrease since they will stop buying too, and so on.

Causes of deflation

Deflation occurs when the supply of goods and services in an economy is greater than the demand: companies are forced to reduce prices in order to be able to sell production and not be forced to accumulate stocks. This mismatch between supply and demand can come from two causes: insufficient demand or excess supply.

-Insufficient demand: For example, in the Great Depression that occurred in the United States at the end of the 1920s, the collapse of the stock markets and the collapse of the financial system drastically reduced the spending capacity of families, inducing a deflationary spiral: the CPI fell 24% between August 1929 and March 1933.

– Excess supply: The best example is the current situation. In the last years of the strong expansionary cycle of the 1990s, companies undertook numerous investment projects seduced by the “new economy”. The non-crystallization of these expectations left the productive sector (particularly in the US) with a large excess of capacity that has not yet been purged: in the United States the use of capacity was (April 2003) at 74%, seven points below the 1972-2002 average. The impact of this imbalance on prices can be accentuated by structural changes in the world economy that imply an increase in productivity or competition between companies, as has happened in recent years with the progressive disappearance of barriers to world trade and the liberalization of basic sectors (telephony, transport, energy) in many countries.

Measures against deflation

Monetary and fiscal policy can be used to deal with deflation.

– Monetary policy: One of the ways to deal with deflation is to reduce the value of money, for which more money (Currency) must be placed in circulation, complemented by the decrease in the interest rate, which encourages credit consumption and investment, thus reactivating demand.

By lowering the interest rate, it is no longer profitable to have money in financial institutions, so people will prefer to invest or spend it. This circumstance can be used by investors to expand their companies, something that is difficult due to the consequences of deflation, but that can be carried out by searching for new markets.

-Fiscal policy: Fiscal policy involves an increase in public spending, a reduction in taxes and an increase in transfers. In the first case, an attempt is made to supply the absence of demand from the private sector with that of the public sector, which in turn becomes an important generator of employment, which is very attractive, since unemployment is one of the direct causes. of deflation. In the second case, the reduction of taxes means more money to spend in private hands, and an incentive to consumption, but at the same time less money in the hands of the state, and if it does not have enough money, it will be difficult for it to boost demand through consumption. public, so if you lean towards the first case too, you will have to finance the increase in public spending with indebtedness. The increase in transfers is an attempt to decentralize public consumption, since transfers are made to different decentralized entities such as departments, municipalities and districts.

Although in principle, the general decrease in prices (deflation) may seem positive to a good part of consumers, this concept will change when the consequences begin to be seen, such as the closure of companies and the dismissal of workers. .

Unemployment is an inevitable consequence of deflation (companies will have to work at a loss and some will close), and even if prices are low, it is of little use if you do not have the resources to acquire them, and those who have the resources will prefer, as has already been said, he stated, don’t spend them waiting for ‘better’ prices.