Effects of Deflation

By: EconomyWatch   Date: 14 October 2010

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Deflation is an economic theory, which deals with the general reduction in the price levels or in the prices of a type of good or asset. The effects of Deflation are immense on the economic conditions of a particular nation. With respect to the effects of Deflation, one should not mix up the concept with that of a temporary decrease in the prices. Deflation affects the general price fall in a sustained manner, exerting more or less permanent influence on a country's economy.

Following are the diverse ways in which Deflation impacts the economic condition of a country:

  • Deflation results in the improvement of production efficiency, due to lowering of the overall price of commodities. The production efficiency of a country develops at a time when the economic producers of goods and services are propelled sufficiently by a promise of enhancing their profit margins, by improving the overall standard of their products. At this point, the consumers are required to make low payment while buying those goods. This increases the purchasing power, and culminates into an economic condition called Deflation.

  • Deflation is considered to be a natural phenomenon, as far as hard currency economies are concerned. In this case, the rate of increase in money supply is not maintained in proportion to the positive population and the general growth of the economy. Under such circumstance, the per head availability of hard money reduces. This leads to the escalation in the purchasing power of each unit of currency. This permanent deflationary condition is visible in the later part of the 19th century, with noticeable developments in the economy under the above-mentioned conditions.

    Hard money economies claim that the economy involves no rigidity. Hence Deflation is a most welcome phenomenon here, for the economy to make diversified ventures in other fields as well, owing to the lowering of prices. This is always a good deflationary effect, as far as economic growth and development is concerned.

  • Deflation generally exerts negative impact on a country's economic conditions. This is because the advent of Deflation acts as a tax on the borrowers and the liquid asset holders simultaneously. This in turn, acts as a benefit, as far as the liquid cash and asset holders and the savers are concerned. Thus, Deflation is just the opposite economic situation to Inflation, levying tax on money lenders and holders, in the interest of short-term consumption and that of the borrowers. As per the contemporary economic thoughts, the concept of Deflation is associated with a certain amount of risk. Here, the risk-adjusted return of assets becomes negative in nature, thereby encouraging the purchasers and investors to gather money, rather than investing it in solid and assured securities. This leads to the formation of a theoretical condition known as Liquidity Trap. Liquidity trap is regarded as a critical condition as it stagnates the economy, where the nominal rate of interest becomes zero or close to zero.

  • Deflation discourages both investment and expenditure. In contemporary economic conditions, the penalties associated with Deflation have increased. This escalation results from lengthy loan terms , essential for the continuation of general commercial activities and building of a country. In fact, Deflation brings with it, a fall in the aggregate demand. Emergence of deflationary spiral is considered to be one of the primary impacts of Deflation. In this case, there is fall in the prices, resulting in the creation of a vicious circle. This makes a problematic situation to worsen, rather than reaching any amicable solution. Perhaps, the greatest instance of deflationary spiral is the Great Depression, occurring in the United States of America during the Civil War.

    With the emergence of deflationary spiral, the solution to the decreasing collective demand acts as an incentive to the central bank of a nation, asking for the expansion in the supply of money. It also stimulates the country's fiscal authorities to increase demand, as well as lend money at low interest rates than those available with the private commercial bodies.

  • According to the Monetarist Theory of Deflation, Deflation affects an economy by decreasing the velocity of money or the number of commercial transactions more or less permanently. This leads to the emergence of a remarkable contraction in the supply of money.


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