The last unit was
dominated by the discussion on inflation. In this unit, we shall concentrate on
deflation in
order to be able to
distinguish between two of them.
When the prices of
most goods and services are rising over time, the economy is said to be
experiencing
inflation. Prior, to
1950, several European countries including Germany, France and Italy had
periods when
prices rose very
rapidly. This usually occurred during wartime and in the years of rationing
that followed.
These wartime periods
of inflation were often followed by periods of deflation, during which the
prices of
most goods and
services fell. In some countries, such as Sweden, the Netherlands and the U.K.,
the result of
these offsetting
periods of inflation and deflation was that over the long run, the level of
prices was fairly
constant. The last
significant deflation in Europe occurred during 1929 – 33, the initial phase of
the Great
Depression. Since
then, inflation without offsetting deflation has become the normal state of
affairs.
Deflation is a
situation in which the prices of most goods and services are falling over time.
Meaning/Definitions and Causes of Deflation
Deflation is a
reduction in the general price level due to a decrease in the economic activity
of a nation. The
price levels as well
as national income; output and employment will all fall. During the twentieth
century, the
only sustained period
of deflation in the U.K. existed between 1920 and 1938 when the general prices
level
fell by almost 50%.
Government introduced deflationary policies for several reasons to decrease the
rate of
inflation, to cut the
volume of import or to prevent the economy from becoming “overhead.” Among the
deflationary policies
available to the government are increases in level of taxation, and “credit
sequences.”
Deflation is also the
conversion of a factor such as a wage, the cost of raw materials, etc, from a
nominal
to a real amount,
when measured in monetary terms. For example, the nominal increase in the price
of
consumer durables
must be divided by the rate of inflation to arrive at the real increase in the
price. Also,
Deflationary Gap is
the difference between the amount that is actually spent in an economy and the
amount
that would have to be
spent in order to maintain output at a level corresponding to employment.
Furthermore,
Deflation refers to a persistent fall in general price level due to a reduction
in the amount of
money in circulation.
It is the opposite of inflation.
It is a continuous
fall in the price level of goods and service in a country as a result of
decrease in the
volume of money in
circulation used in the exchange of large available goods and service.
From the foregoing,
the cause of Deflation is summarized below.
· Under population
· Increase in
production
· Increase in taxation
· Increase in bank rate
· Compulsory bank
savings
· Executive price
control
· Surplus budget or
reduction in government expenditure.
Effects of Deflation
Since deflation is
the opposite of inflation, its effects are the opposite of the effects of
inflation already
discussed in Unit
Seven.
(a) Effects on Incomes
People with fixed
incomes – salary earners, pensioners benefit from the fall in price level while
people
whose income are not
fixed lose. Income of businessmen, manufactures, shareholders fall because of
fall in profits. The
real value of fixed income earners rise when prices fall.
(b) Fall in
investment and employment: Fall in profits leads to decline in investment
and consequently
in employment. The
total output (or national income) working through the multiplier process also
falls.
(c) Borrowers lose while lenders gain,
since the repaid debts can buy more because of falling prices
(d) Exports are
encouraged while consumption of imported goods fall because their prices are
relatively
dearer than domestic
projects.
(e) Due to falling
imports and rising exports, foreign exchange rises while balance of payments
problems or
deficits are
eliminated or corrected.
The effects of
deflation are further summarized as follows:
* Money gains more
value
* It encourages
export
* It discourages
imports
* Decrease in
investment
* It encourages
savings
* Reduction in profit
* Fall in prices of
goods and services
* It causes
unemployment
* Money lenders gain
at the expense of borrowers
* Improvement in the
balance of payments
* Fixed income
earners will gain
* It will instill
sense of hard work on the people.
Control of Deflation
Earlier, we explained
that economic theory distinguishes two “types” of Inflation – demand-pull
inflation and
cost-push inflation.
In practice, demand-pull and cost-push inflation tend to co-exist, though it is
possible in
theory at least to
distinguish “demand pull” and cost-push” inflation.
If demand-pull
inflation is diagnosed, the appropriate policy is one which reduces the level
of demand –
what is called
deflationary policy – if on the other hand, cost-push inflation is diagnosed,
deflation would not
be appropriate.
Rather a policy to restrain cost increases is necessary. In practice, the
appropriate policy
would depend upon the
nature and source of the cost increases.
The terms deflation,
reflation “both refer to demand. Deflation means a reduction in demand.
Reflation is
the opposite – an
increase in demand. The odd one out is inflation, since it refers to prices.
Curiously or
perhaps not so
curiously, there is no single word, which is the opposite to inflation – we
have to use a phrase
such as “ a fall in
the price level.”
Deflation can be
checked by reversing those measures for checking inflation: Specifically, these
measures
are as follows:
(a) Government should encourage investment by
reducing the bank rate thus making it cheaper for investors,
businessmen and
consumers to borrow money. That is, expansionary monetary policy that
liberalises
credit facilities can
remedy deflation.
(b) Reduction of
Taxes
The government should
also reduce taxes (particularly income taxes) to increase people’s disposable
income and thus
purchasing powers.
(c) Increase in
Government Expenditure
The Government
expenditure should rise in order to increase employment and personal income of
consumers.
(d) Increase in
Salaries and Wages
There should be a
general increase in salaries and wages so as to raise consumers’ purchasing
power
and push up prices to
acceptable levels (stable prices).
The control of
Deflation is further summarized as follows:-
(i) Deficit budget
(ii) Increase in
wages
(iii) Reduction in
bank rate
(iv) Reduction in
income tax
(v) The use of Open
Market Operation
Conclusion
Deflation is almost
the opposite of Inflation. This is experienced when the amount of money in
circulation is
not sufficient. In
other words, the total demand for money is greater than the available amount.
This may be
due to the
contraction of money supply with a view to raising the value of the national
currency.
Volume of goods and
services in the economy is expanding without corresponding increase in the
supply of
money. OR the same
volume of goods and services. But part of money circulating over them have been
withdrawn as
indicated above leaving more goods and services with little amount of money.
The general result is
the appreciation of money value. This leads to a fall in the general level of
prices.
With the little
amount of the money in your possession, you can purchase as many goods and
service as
possible. This is
deflation. It reduces the National Income as it reduces personal income. This
is general
distress resulting
from jungle economic activities. Its effects could be more caustic than
inflation both in the
short-run and in the
long-run.
By deflation; we mean
a time when most prices and costs are falling. The effect of deflation is the
opposite of
inflation. During the period of deflation, the entrepreneurs lose because of
the declining profit of
their investment. The
creditors and fixed receivers tend to gain at the expense of debtors. Wage
earners and
pensioners obtain
increased purchasing power for their income. Debtors gain at the expense of the
creditors.
In terms of
production, profit margin decline, entrepreneurs are less inclined to expand
their operation.
This decline in
production leads to growing unemployment to labor and capital.
The standard of
living falls. When an economy faces this type of depression, private and public
spending
has to be stimulated
to encourage and accelerate production, which creates more job and more real
income.
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