Deflation (economics)
Encyclopedia
In economics
, deflation is a decrease in the general price level
of goods and services. Deflation occurs when the inflation
rate falls below 0% (a negative inflation rate
). This should not be confused with disinflation
, a slow-down in the inflation rate (i.e. when inflation declines to lower levels). 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.
Economists generally believe that deflation is a problem in a modern economy because of the danger of a deflationary spiral (explained below). Deflation is correlated with depression
s – including the Great Depression
, as banks
defaulted on depositors. Additionally, deflation may cause the economy to enter a liquidity trap
. However, historically not all episodes of deflation correspond with periods of poor economic growth.
(Investment and Saving equilibrium/ Liquidity Preference 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 this 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. This can produce a liquidity trap
. A central bank cannot, normally, charge negative interest for money, and even charging zero interest often produces less stimulative 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 produces 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 adherence 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 more scarce; 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 acceleration 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 (due to increased productivity) without an increase in the supply of money, or (as with the Great Depression and possibly Japan in the early 1990s) 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:
Supply-side causes are:
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. 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.
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. More recently Alan Greenspan cited the time lag as taking between 12 and 13 quarters. Bonds, equities and commodities have been suggested as reservoirs for buffering changes in money supply.
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 (as in Japan, most recently). 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.
. Partly because of overcapacity and market saturation and partly as a result of the Smoot-Hawley Tariff Act
, international trade contracted sharply, severely reducing demand for goods, thereby idling a great deal of capacity, and setting off a string of bank failures. A similar situation in Japan, beginning with the stock and real estate market collapse in the early 1990s, was arrested by the Japanese government preventing the collapse of most banks and taking over direct control of several in the worst condition. These occurrences are the matter of intense debate.
(1890) 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.
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 (or unusually unreliable), 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 a 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.
Deflation was present during most economic depressions in US history 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, and because confused pricing signals cause malinvestment, in the form of under-investment.
In this sense it is the opposite of the more usual scenario of inflation, whose effect is to tax currency holders and lenders (savers) and use the proceeds to subsidize borrowers, including governments, and to cause malinvestment as overinvestment. Thus inflation encourages short term consumption and can similarly over-stimulate investment in projects that may not be worthwhile in real terms (for example the housing
or dot.com
bubbles), while deflation retards investment even when there is a real-world demand not being met. In modern economies, deflation is usually caused by a drop in aggregate demand, and is associated with economic depression, as occurred in the Great Depression
and the Long Depression
.
Nobel laureate Friedrich Hayek
, an Austrian Economist, stated of deflation during the Great Depression:
While an increase in the purchasing power of one's money benefits some, it amplifies the sting of debt for others: after a period of deflation, the payments to service 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 an effective increase in a loan's interest rate. If, as during the Great Depression
in the United States, deflation averages 10% per year, even an interest-free 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. With interest rates near zero, debt relief
becomes an increasingly important tool in managing deflation.
In recent times, as loan terms have grown in length and loan financing (or leveraging) is common among many types of investments, the costs of deflation to lenders has grown larger. Deflation can discourage private investment, because there is reduced expectations on future profits when future prices are lower. Consequently with reduced private investments, spiraling deflation can cause a collapse in aggregate demand
. Without the "hidden risk of inflation", it may become more prudent for institutions to hold on to money, and not to spend or invest it (burying money). They are therefore rewarded by holding money. This "hoarding" behavior is seen as undesirable by most economists, as Hayek points out:
Some believe that, in the absence of large amounts of debt, deflation would be a welcome effect because the lowering of prices increases purchasing power
.
Since deflationary periods disfavor debtors (including most farmers), they are often periods of rising populist backlash. For example, in the late 19th century, populists in the US wanted debt relief or to move off the new gold standard, and onto: a silver standard (the supply of silver was increasing relatively faster than the supply of gold making silver less deflationary than gold), bimetal standard, or paper money like the recently-ended Greenback
s.
, where a problem exacerbates its own cause. The Great Depression
was regarded by some as a deflationary spiral. A deflationary spiral is the modern macroeconomic version of the general glut
controversy of the 19th century. Another related idea is Irving Fisher
's theory that excess debt can cause a continuing deflation
. Whether deflationary spirals can actually occur is controversial, with its possibility being disputed by freshwater economists (including the Chicago school of economics) and Austrian School
economists.
") and may use extraordinary methods to increase the supply of money, e.g. purchasing financial assets of a type not usually used by the central bank as reserves (such as mortgage backed securities). Before he was Chairman
of the United States Federal Reserve
, Ben Bernanke
claimed in 2002, "...sufficient injections of money will ultimately always reverse a deflation", although Japan's deflationary spiral was not broken by this very sort of quantitative easing.
Until the 1930s, it was commonly believed by economists that deflation
would cure itself. As prices decreased, demand would naturally increase and the economic system would correct itself without outside intervention.
This view was challenged in the 1930s during the Great Depression
. Keynesian economist
s argued that the economic system was not self-correcting with respect to deflation and that governments and central banks had to take active measures to boost demand through tax cuts or increases in government spending. Reserve requirements from the central bank were high compared to recent times. So were it not for redemption of currency for gold (in accordance with the gold standard), the central bank could have effectively increased money supply by simply reducing the reserve requirements and through open market operations (e.g., buying treasury bonds for cash) to offset the reduction of money supply in the private sectors due to the collapse of credit (credit is a form of money).
With the rise of monetarist
ideas, the focus in fighting deflation was put on expanding demand by lowering interest rates (i.e., reducing the "cost" of money). This view has received a setback in light of the failure of accommodative policies in both Japan and the US to spur demand after stock market shocks in the early 1990s and in 2000–2002, respectively. Austrian economists worry about the inflationary impact of monetary policies on asset prices. Sustained low real rates can cause higher asset prices and excessive debt accumulation. Therefore, lowering rates may prove to be only a temporary palliative, aggravating an eventual debt deflation crisis.
With interest rates near zero, debt relief
becomes an increasingly important tool in managing deflation.
. When deflation takes hold, it requires "special arrangements
" to lend money at a zero nominal rate of interest (which could still be a very high real rate of interest, due to the negative inflation rate) in order to artificially increase the money supply.
experienced a long period of deflation which did not end until the 4th quarter of 2004 http://www.info.gov.hk/censtatd/eng/hkstat/fas/cpi/cpi_adjust_index.html. Many East Asia
n currencies devalued following the crisis. The Hong Kong dollar
however, was pegged to the US Dollar, leading to an adjustment instead by a deflation of consumer prices
. The situation was worsened by the increasingly cheap exports from Mainland China
, and weak consumer confidence in Hong Kong. This deflation was accompanied by an economic slump that was more severe and prolonged than those of the surrounding countries that devalued their currencies in the wake of the Asian financial crisis.
'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."
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.
and the government tried to eliminate it by reducing interest rates and 'quantitative easing
', but did not create a sustained increase in broad money and deflation persisted. In July 2006, the zero-rate policy was ended.
Systemic reasons for deflation in Japan can be said to include:
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%.
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 third was between 1930–1933 when the rate of deflation was approximately 10 percent/year, 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 when the Federal Reserve was supposed to accommodate that demand, it instead contracted the money supply by 30% in enforcement of its new real bills doctrine
, so banks toppled one-by-one (because they were unable to meet the sudden demand for cash— see Fractional-reserve banking
). From the standpoint of the Fisher equation
(see above), there was a concomitant drop both in money supply (credit) 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.
in 1948. There has only been one period of deflation since, in 2008-9.
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. 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. 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.
the British
pound sterling
was removed from the gold standard. The motivation for this policy change was to finance World War I; one of the results was inflation, and a rise in the gold price, along with the corresponding drop in international exchange rates for the pound. When the pound was returned to the gold standard after the war it was done on the basis of the pre-war gold price, which, since it was higher than equivalent price in gold, required prices to fall to realign with the higher target value of the pound.
The UK experienced deflation of approx 10% in 1921, 14% in 1922, and 3 to 5% in the early 1930s.
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
, deflation is a decrease in the general price level
Price index
A price index is a normalized average of prices for a given class of goods or services in a given region, during a given interval of time...
of goods and services. Deflation occurs when the inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
rate falls below 0% (a negative inflation rate
Inflation rate
In economics, the inflation rate is a measure of inflation, the rate of increase of a price index . It is the percentage rate of change in price level over time. The rate of decrease in the purchasing power of money is approximately equal.The inflation rate is used to calculate the real interest...
). This should not be confused with disinflation
Disinflation
Disinflation is a decrease in the rate of inflation – a slowdown in the rate of increase of the general price level of goods and services in a nation's gross domestic product over time. It is the opposite of reflation. Disinflation occurs when the increase in the “consumer price level” slows down...
, a slow-down in the inflation rate (i.e. when inflation declines to lower levels). Inflation reduces the real value of money
Money
Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value; and, occasionally in the past,...
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.
Economists generally believe that deflation is a problem in a modern economy because of the danger of a deflationary spiral (explained below). Deflation is correlated with depression
Depression (economics)
In economics, a depression is a sustained, long-term downturn in economic activity in one or more economies. It is a more severe downturn than a recession, which is seen by some economists as part of the modern business cycle....
s – including the Great Depression
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...
, as banks
Fractional-reserve banking
Fractional-reserve banking is a form of banking where banks maintain reserves that are only a fraction of the customer's deposits. Funds deposited into a bank are mostly lent out, and a bank keeps only a fraction of the quantity of deposits as reserves...
defaulted on depositors. Additionally, deflation may cause the economy to enter a liquidity trap
Liquidity trap
A liquidity trap is a situation described in Keynesian economics in which injections of cash into an economy by a central bank fail to lower interest rates and hence to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as...
. However, historically not all episodes of deflation correspond with periods of poor economic growth.
Causes and corresponding types
In the IS/LM modelIS/LM model
The IS/LM model is a macroeconomic tool that demonstrates the relationship between interest rates and real output in the goods and services market and the money market...
(Investment and Saving equilibrium/ Liquidity Preference 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
Demand
- Economics :*Demand , the desire to own something and the ability to pay for it*Demand curve, a graphic representation of a demand schedule*Demand deposit, the money in checking accounts...
. 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 this idles the productive capacity, investment also falls, leading to further reductions in aggregate demand
Aggregate demand
In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...
. This is the deflationary spiral. An answer to falling aggregate demand is stimulus
Stimulus (economic)
In economics, stimulus refers to attempts to use monetary or fiscal policy to stimulate the economy. Recently "stimulus" has become particularly associated with Keynesian economics and the theory that government spending projects can generate economic growth in a recession...
, either from the central bank, by expanding the money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...
, 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. This can produce a liquidity trap
Liquidity trap
A liquidity trap is a situation described in Keynesian economics in which injections of cash into an economy by a central bank fail to lower interest rates and hence to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as...
. A central bank cannot, normally, charge negative interest for money, and even charging zero interest often produces less stimulative effect than slightly higher rates of interest. In a closed economy
Autarky
Autarky is the quality of being self-sufficient. Usually the term is applied to political states or their economic policies. Autarky exists whenever an entity can survive or continue its activities without external assistance. Autarky is not necessarily economic. For example, a military autarky...
, 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
Carry (investment)
The carry of an asset is the return obtained from holding it , or the cost of holding it .For instance, commodities are usually negative carry assets, as they incur storage costs or may suffer from depreciation, but in some circumstances, appropriately hedged commodities can be positive carry...
trade, and devalues the currency. A devalued currency produces 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
Velocity of money
300px|thumb|Similar chart showing the velocity of a broader measure of money that covers M2 plus large institutional deposits, M3. The US no longer publishes official M3 measures, so the chart only runs through 2005....
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 adherence 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 more scarce; and consequently, the purchasing power of each unit of currency increases. Deflation occurs when improvements in production efficiency
Efficiency
Efficiency in general describes the extent to which time or effort is well used for the intended task or purpose. It is often used with the specific purpose of relaying the capability of a specific application of effort to produce a specific outcome effectively with a minimum amount or quantity of...
lower the overall price of goods. Competition
Competition
Competition is a contest between individuals, groups, animals, etc. for territory, a niche, or a location of resources. It arises whenever two and only two strive for a goal which cannot be shared. Competition occurs naturally between living organisms which co-exist in the same environment. For...
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
Productivity improving technologies (historical)
Productivity improving technologies date back to antiquity, with rather slow progress until the late Middle Ages. Technological progress was aided by literacy and the diffusion of knowledge that accelerated after the spinning wheel spread to Western Europe in the 13th century...
and reduced transportation cost created structural deflation during the acceleration productivity
Productivity improving technologies (historical)
Productivity improving technologies date back to antiquity, with rather slow progress until the late Middle Ages. Technological progress was aided by literacy and the diffusion of knowledge that accelerated after the spinning wheel spread to Western Europe in the 13th century...
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
World War I
World War I , which was predominantly called the World War or the Great War from its occurrence until 1939, and the First World War or World War I thereafter, was a major war centred in Europe that began on 28 July 1914 and lasted until 11 November 1918...
, 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
Mainstream economics
Mainstream economics is a loose term used to refer to widely-accepted economics as taught in prominent universities and in contrast to heterodox 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 (due to increased productivity) without an increase in the supply of money, or (as with the Great Depression and possibly Japan in the early 1990s) the demand for goods going down combined with a decrease in the money supply. Studies of the Great Depression by Ben Bernanke
Ben Bernanke
Ben Shalom Bernanke is an American economist, and the current Chairman of the Federal Reserve, the central bank of the United States. During his tenure as Chairman, Bernanke has overseen the response of the Federal Reserve to late-2000s financial crisis....
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 IIWorld War IIWorld War II, or the Second World War , was a global conflict lasting from 1939 to 1945, involving most of the world's nations—including all of the great powers—eventually forming two opposing military alliances: the Allies and the Axis...
until the 1960s, but no deflation.
- See: Deflation#Scarcity of official money and Long Depression#Myth of the Long Depression.
- Productivity and deflation are discussed in a 1940 study by the Brookings InstitutionBrookings InstitutionThe Brookings Institution is a nonprofit public policy organization based in Washington, D.C., in the United States. One of Washington's oldest think tanks, Brookings conducts research and education in the social sciences, primarily in economics, metropolitan policy, governance, foreign policy, and...
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. By the late 1920s, most goods were over supplied, which contributed to high unemployment during the Great Depression.
- Cash building (hoarding) 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.
Money supply side deflation
From a monetarist perspective, deflation is caused primarily by a reduction in the velocity of money and/or the amount of money supplyMoney supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...
per person.
A historical analysis of money velocity and monetary base
Monetary base
In economics, the monetary base is a term relating to the money supply , the amount of money in the economy...
shows an inverse correlation: for a given percentage decrease in the monetary base
Monetary base
In economics, the monetary base is a term relating to the money supply , the amount of money in the economy...
the result is nearly equal percentage increase in money velocity. This is to be expected because monetary base (MB), velocity
Velocity of money
300px|thumb|Similar chart showing the velocity of a broader measure of money that covers M2 plus large institutional deposits, M3. The US no longer publishes official M3 measures, so the chart only runs through 2005....
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.
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. More recently Alan Greenspan cited the time lag as taking between 12 and 13 quarters. Bonds, equities and commodities have been suggested as reservoirs for buffering changes in money supply.
Credit deflation
In modern credit-based economies, deflation may be caused by the central bank initiating higher interest rates (i.e., to 'control' inflation), 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 glutGlut
Glut or GLUT may refer to:* Glut: Mastering Information Through The Ages, a book by Alex Wright* Glucose transporter , a family of membrane proteins in biology* OpenGL Utility Toolkit , a computer program library...
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 (as in Japan, most recently). 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.
Historical examples of credit deflation
This cycle has been traced out on the broad scale during the Great DepressionGreat Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...
. Partly because of overcapacity and market saturation and partly as a result of the Smoot-Hawley Tariff Act
Smoot-Hawley Tariff Act
The Tariff Act of 1930, otherwise known as the Smoot–Hawley Tariff was an act, sponsored by United States Senator Reed Smoot and Representative Willis C. Hawley, and signed into law on June 17, 1930, that raised U.S. tariffs on over 20,000 imported goods to record levels.The overall level tariffs...
, international trade contracted sharply, severely reducing demand for goods, thereby idling a great deal of capacity, and setting off a string of bank failures. A similar situation in Japan, beginning with the stock and real estate market collapse in the early 1990s, was arrested by the Japanese government preventing the collapse of most banks and taking over direct control of several in the worst condition. These occurrences are the matter of intense debate.
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. WellsDavid Ames Wells
David Ames Wells was an American engineer, textbook author, economist and advocate of low tariffs.-Biography:...
(1890) 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.
In economies with an unstable currency, barter and other alternate currency arrangements such as dollarization
Dollarization
Dollarization occurs when the inhabitants of a country use foreign currency in parallel to or instead of the domestic currency. The term is not only applied to usage of the United States dollar, but generally to the use of any foreign currency as the national currency.The biggest economies to have...
are common, and therefore when the 'official' money becomes scarce (or unusually unreliable), 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 a 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.
Effects
The effects of deflation are:- Decreasing nominal prices for goods and services
- Increasing real value of cash money and all assets denominated in cash terms
- May decrease investment if cash holdings are seen as preferable
- May discourage lending in favor of simply hoarding money
- Harms debtors whose original debt remains fixed even as their income and value falls — for example, a house ends up "underwater", even as the owner's income falls too much to even keep up payments
- Benefits recipients of fixed incomes
Deflation was present during most economic depressions in US history 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, and because confused pricing signals cause malinvestment, in the form of under-investment.
In this sense it is the opposite of the more usual scenario of inflation, whose effect is to tax currency holders and lenders (savers) and use the proceeds to subsidize borrowers, including governments, and to cause malinvestment as overinvestment. Thus inflation encourages short term consumption and can similarly over-stimulate investment in projects that may not be worthwhile in real terms (for example the housing
Real estate bubble
A real estate bubble or property bubble is a type of economic bubble that occurs periodically in local or global real estate markets...
or dot.com
Dot-com bubble
The dot-com bubble was a speculative bubble covering roughly 1995–2000 during which stock markets in industrialized nations saw their equity value rise rapidly from growth in the more...
bubbles), while deflation retards investment even when there is a real-world demand not being met. In modern economies, deflation is usually caused by a drop in aggregate demand, and is associated with economic depression, as occurred in the Great Depression
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...
and the Long Depression
Long Depression
The Long Depression was a worldwide economic crisis, felt most heavily in Europe and the United States, which had been experiencing strong economic growth fueled by the Second Industrial Revolution in the decade following the American Civil War. At the time, the episode was labeled the Great...
.
Nobel laureate Friedrich Hayek
Friedrich Hayek
Friedrich August Hayek CH , born in Austria-Hungary as Friedrich August von Hayek, was an economist and philosopher best known for his defense of classical liberalism and free-market capitalism against socialist and collectivist thought...
, an Austrian Economist, stated of deflation during the Great Depression:
- I agree with Milton Friedman that once the Crash had occurred, the Federal Reserve System pursued a silly deflationary policy. I am not only against inflation but I am also against deflation. So, once again, a badly programmed monetary policy prolonged the depression.
- Interview with Diego Pizano (1979)
While an increase in the purchasing power of one's money benefits some, it amplifies the sting of debt for others: after a period of deflation, the payments to service 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 an effective increase in a loan's interest rate. If, as during the Great Depression
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...
in the United States, deflation averages 10% per year, even an interest-free 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
Federal funds rate
In the United States, the federal funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend...
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. With interest rates near zero, debt relief
Debt relief
Debt relief is the partial or total forgiveness of debt, or the slowing or stopping of debt growth, owed by individuals, corporations, or nations. From antiquity through the 19th century, it refers to domestic debts, in particular agricultural debts and freeing of debt slaves...
becomes an increasingly important tool in managing deflation.
In recent times, as loan terms have grown in length and loan financing (or leveraging) is common among many types of investments, the costs of deflation to lenders has grown larger. Deflation can discourage private investment, because there is reduced expectations on future profits when future prices are lower. Consequently with reduced private investments, spiraling deflation can cause a collapse in aggregate demand
Aggregate demand
In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...
. Without the "hidden risk of inflation", it may become more prudent for institutions to hold on to money, and not to spend or invest it (burying money). They are therefore rewarded by holding money. This "hoarding" behavior is seen as undesirable by most economists, as Hayek points out:
- It is agreed that hoarding money, whether in cash or in idle balances, is deflationary in its effects. No one thinks that deflation is in itself desirable.
Some believe that, in the absence of large amounts of debt, deflation would be a welcome effect because the lowering of prices increases purchasing power
Purchasing power
Purchasing power is the number of goods/services that can be purchased with a unit of currency. For example, if you had taken one dollar to a store in the 1950s, you would have been able to buy a greater number of items than you would today, indicating that you would have had a greater purchasing...
.
Since deflationary periods disfavor debtors (including most farmers), they are often periods of rising populist backlash. For example, in the late 19th century, populists in the US wanted debt relief or to move off the new gold standard, and onto: a silver standard (the supply of silver was increasing relatively faster than the supply of gold making silver less deflationary than gold), bimetal standard, or paper money like the recently-ended Greenback
Greenback
Greenback may refer to:In currency:* Greenback , a fiat currency issued during the American Civil War**United States Note**Demand Note, issued in 1861–62* A modern United States Federal Reserve Note...
s.
Deflationary spiral
A deflationary spiral is a situation where decreases in price lead to lower production, which in turn leads to lower wages and demand, which leads to further decreases in price. Since reductions in general price level are called deflation, a deflationary spiral is when reductions in price lead to a vicious circleVirtuous circle and vicious circle
A virtuous circle and a vicious circle are economic terms. They refer to a complex of events that reinforces itself through a feedback loop. A virtuous circle has favorable results, while a vicious circle has detrimental results...
, where a problem exacerbates its own cause. The Great Depression
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...
was regarded by some as a deflationary spiral. A deflationary spiral is the modern macroeconomic version of the general glut
General glut
In macroeconomics, a general glut is when supply exceeds demand, specifically, when there is more production in all fields of production in comparison with what resources are available to consume said production....
controversy of the 19th century. Another related idea is Irving Fisher
Irving Fisher
Irving Fisher was an American economist, inventor, and health campaigner, and one of the earliest American neoclassical economists, though his later work on debt deflation often regarded as belonging instead to the Post-Keynesian school.Fisher made important contributions to utility theory and...
's theory that excess debt can cause a continuing deflation
Debt deflation
Debt deflation is a theory of economic cycles, which holds that recessions and depressions are due to the overall level of debt shrinking : the credit cycle is the cause of the economic cycle....
. Whether deflationary spirals can actually occur is controversial, with its possibility being disputed by freshwater economists (including the Chicago school of economics) and Austrian School
Austrian School
The Austrian School of economics is a heterodox school of economic thought. It advocates methodological individualism in interpreting economic developments , the theory that money is non-neutral, the theory that the capital structure of economies consists of heterogeneous goods that have...
economists.
Counteracting deflation
During severe deflation, targeting an interest rate (the usual method of determining how much money to create) may be ineffective, because even lowering the short-term interest rate to zero may result in a real interest rate which is too high to attract credit-worthy borrowers. Thus the central bank must directly set a target for the quantity of money (called "quantitative easingQuantitative easing
Quantitative easing is an unconventional monetary policy used by central banks to stimulate the national economy when conventional monetary policy has become ineffective. A central bank buys financial assets to inject a pre-determined quantity of money into the economy...
") and may use extraordinary methods to increase the supply of money, e.g. purchasing financial assets of a type not usually used by the central bank as reserves (such as mortgage backed securities). Before he was Chairman
Chairman of the Federal Reserve
The Chairman of the Board of Governors of the Federal Reserve System is the head of the central banking system of the United States. Known colloquially as "Chairman of the Fed," or in market circles "Fed Chairman" or "Fed Chief"...
of the United States Federal Reserve
Federal Reserve System
The Federal Reserve System is the central banking system of the United States. It was created on December 23, 1913 with the enactment of the Federal Reserve Act, largely in response to a series of financial panics, particularly a severe panic in 1907...
, Ben Bernanke
Ben Bernanke
Ben Shalom Bernanke is an American economist, and the current Chairman of the Federal Reserve, the central bank of the United States. During his tenure as Chairman, Bernanke has overseen the response of the Federal Reserve to late-2000s financial crisis....
claimed in 2002, "...sufficient injections of money will ultimately always reverse a deflation", although Japan's deflationary spiral was not broken by this very sort of quantitative easing.
Until the 1930s, it was commonly believed by economists that deflation
would cure itself. As prices decreased, demand would naturally increase and the economic system would correct itself without outside intervention.
This view was challenged in the 1930s during the Great Depression
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...
. Keynesian economist
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...
s argued that the economic system was not self-correcting with respect to deflation and that governments and central banks had to take active measures to boost demand through tax cuts or increases in government spending. Reserve requirements from the central bank were high compared to recent times. So were it not for redemption of currency for gold (in accordance with the gold standard), the central bank could have effectively increased money supply by simply reducing the reserve requirements and through open market operations (e.g., buying treasury bonds for cash) to offset the reduction of money supply in the private sectors due to the collapse of credit (credit is a form of money).
With the rise of monetarist
Monetarism
Monetarism is a tendency in economic thought that emphasizes the role of governments in controlling the amount of money in circulation. It is the view within monetary economics that variation in the money supply has major influences on national output in the short run and the price level over...
ideas, the focus in fighting deflation was put on expanding demand by lowering interest rates (i.e., reducing the "cost" of money). This view has received a setback in light of the failure of accommodative policies in both Japan and the US to spur demand after stock market shocks in the early 1990s and in 2000–2002, respectively. Austrian economists worry about the inflationary impact of monetary policies on asset prices. Sustained low real rates can cause higher asset prices and excessive debt accumulation. Therefore, lowering rates may prove to be only a temporary palliative, aggravating an eventual debt deflation crisis.
With interest rates near zero, debt relief
Debt relief
Debt relief is the partial or total forgiveness of debt, or the slowing or stopping of debt growth, owed by individuals, corporations, or nations. From antiquity through the 19th century, it refers to domestic debts, in particular agricultural debts and freeing of debt slaves...
becomes an increasingly important tool in managing deflation.
Special borrowing arrangements
When the central bank has lowered nominal interest rates to zero, it can no longer further stimulate demand by lowering interest rates. This is the famous liquidity trapLiquidity trap
A liquidity trap is a situation described in Keynesian economics in which injections of cash into an economy by a central bank fail to lower interest rates and hence to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as...
. When deflation takes hold, it requires "special arrangements
Quantitative easing
Quantitative easing is an unconventional monetary policy used by central banks to stimulate the national economy when conventional monetary policy has become ineffective. A central bank buys financial assets to inject a pre-determined quantity of money into the economy...
" to lend money at a zero nominal rate of interest (which could still be a very high real rate of interest, due to the negative inflation rate) in order to artificially increase the money supply.
In Hong Kong
Following the Asian financial crisis in late 1997, Hong KongHong Kong
Hong Kong is one of two Special Administrative Regions of the People's Republic of China , the other being Macau. A city-state situated on China's south coast and enclosed by the Pearl River Delta and South China Sea, it is renowned for its expansive skyline and deep natural harbour...
experienced a long period of deflation which did not end until the 4th quarter of 2004 http://www.info.gov.hk/censtatd/eng/hkstat/fas/cpi/cpi_adjust_index.html. Many East Asia
East Asia
East Asia or Eastern Asia is a subregion of Asia that can be defined in either geographical or cultural terms...
n currencies devalued following the crisis. The Hong Kong dollar
Hong Kong dollar
The Hong Kong dollar is the currency of the jurisdiction. It is the eighth most traded currency in the world. In English, it is normally abbreviated with the dollar sign $, or alternatively HK$ to distinguish it from other dollar-denominated currencies...
however, was pegged to the US Dollar, leading to an adjustment instead by a deflation of consumer prices
Consumer price index
A consumer price index measures changes in the price level of consumer goods and services purchased by households. The CPI, in the United States is defined by the Bureau of Labor Statistics as "a measure of the average change over time in the prices paid by urban consumers for a market basket of...
. The situation was worsened by the increasingly cheap exports from Mainland China
Mainland China
Mainland China, the Chinese mainland or simply the mainland, is a geopolitical term that refers to the area under the jurisdiction of the People's Republic of China . According to the Taipei-based Mainland Affairs Council, the term excludes the PRC Special Administrative Regions of Hong Kong and...
, and weak consumer confidence in Hong Kong. This deflation was accompanied by an economic slump that was more severe and prolonged than those of the surrounding countries that devalued their currencies in the wake of the Asian financial crisis.
In Ireland
In February 2009, IrelandRepublic of Ireland
Ireland , described as the Republic of Ireland , is a sovereign state in Europe occupying approximately five-sixths of the island of the same name. Its capital is Dublin. Ireland, which had a population of 4.58 million in 2011, is a constitutional republic governed as a parliamentary democracy,...
'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."
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.
In Japan
Deflation started in the early 1990s. The Bank of JapanBank of Japan
is the central bank of Japan. The Bank is often called for short. It has its headquarters in Chuo, Tokyo.-History:Like most modern Japanese institutions, the Bank of Japan was founded after the Meiji Restoration...
and the government tried to eliminate it by reducing interest rates and 'quantitative easing
Quantitative easing
Quantitative easing is an unconventional monetary policy used by central banks to stimulate the national economy when conventional monetary policy has become ineffective. A central bank buys financial assets to inject a pre-determined quantity of money into the economy...
', but did not create a sustained increase in broad money and deflation persisted. In July 2006, the zero-rate policy was ended.
Systemic reasons for deflation in Japan can be said to include:
- Tight monetary conditions. The Bank of Japan kept monetary policy loose only when inflation was below zero, tightening whenever deflation ends.
- Unfavorable demographicsDemographics of JapanThe demographic features of the population of Japan include population density, ethnicity, education level, health of the populace, economic status, religious affiliations and other aspects of the population....
. 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 its birth rate.
- Fallen assetAssetIn financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an 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 estateReal estateIn general use, esp. North American, 'real estate' is taken to mean "Property consisting of land and the buildings on it, along with its natural resources such as crops, minerals, or water; immovable property of this nature; an interest vested in this; an item of real property; buildings or...
in Japan in the 1980s (peaking in late 1989).
- 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 (and the loss realized), 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 EconomistThe EconomistThe Economist is an English-language weekly news and international affairs publication owned by The Economist Newspaper Ltd. and edited in offices in the City of Westminster, London, England. Continuous publication began under founder James Wilson in September 1843...
) 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 (United States or Japanese) 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.
- Stimulus Spending: According to both Austrian and Monetarist economic theory, Keynesian 'stimulus' spending actually has a depressing effect. This is because the government is competing against private industry, and usurping private investment dollars. In 1998, for example, Japan produced a 'stimulus' package of more than 16 trillion Yen, over half of it public works that would have a quashing effect on an equivalent amount of private, wealth-creating economic activity. Overall, Japan's 'stimulus' packages added up to over one hundred trillion Yen, and yet they failed. According to these economic schools, that 'stimulus' money actually perpetuated the problem it was intended to cure.
In November 2009 Japan has returned to deflation, according to the Wall Street Journal. Bloomberg L.P.
Bloomberg L.P.
Bloomberg L.P. is an American privately held financial software, media, and data company. Bloomberg makes up one third of the $16 billion global financial data market with estimated revenue of $6.9 billion. Bloomberg L.P...
reports that consumer prices fell in October 2009 by a near record 2.2%.
In the United States
Major deflations in the US
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
Panic of 1837
The Panic of 1837 was a financial crisis or market correction in the United States built on a speculative fever. The end of the Second Bank of the United States had produced a period of runaway inflation, but on May 10, 1837 in New York City, every bank began to accept payment only in specie ,...
, 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
The Great Deflation
The Great Deflation or the Great Sag refers to the period from 1870 until 1890 in which world prices of goods, materials and labor decreased, although at a low rate of less than 2% annually...
. 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 FriedmanMilton FriedmanMilton Friedman was an American economist, statistician, academic, and author who taught at the University of Chicago for more than three decades...
, prices fell in the United States by 1.7% a year, and in Britain by 0.8% a year.
-
- (Note: David A. WellsDavid Ames WellsDavid Ames Wells was an American engineer, textbook author, economist and advocate of low tariffs.-Biography:...
(1890) gives an account of the period and discusses the great advances in productivity. The productivity gains matched the deflation.
- (Note: David A. Wells
The third was between 1930–1933 when the rate of deflation was approximately 10 percent/year, part of the United States' slide into the Great Depression
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...
, where banks failed and unemployment
Unemployment
Unemployment , as defined by the International Labour Organization, occurs when people are without jobs and they have actively sought work within the past four weeks...
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
Credit (finance)
Credit is the trust which allows one party to provide resources to another party where that second party does not reimburse the first party immediately , but instead arranges either to repay or return those resources at a later date. The resources provided may be financial Credit is the trust...
(money), bankruptcies creating an environment where cash
Monetary base
In economics, the monetary base is a term relating to the money supply , the amount of money in the economy...
was in frantic demand, and when the Federal Reserve was supposed to accommodate that demand, it instead contracted the money supply by 30% in enforcement of its new real bills doctrine
Real bills doctrine
The real bills doctrine holds that issuing money in exchange for real bills is not inflationary. It is best known as "the decried doctrine of the old Bank Directors of 1810: that so long as a bank issues its notes only in the discount of good bills, at not more than sixty days’ date, it cannot go...
, so banks toppled one-by-one (because they were unable to meet the sudden demand for cash— see Fractional-reserve banking
Fractional-reserve banking
Fractional-reserve banking is a form of banking where banks maintain reserves that are only a fraction of the customer's deposits. Funds deposited into a bank are mostly lent out, and a bank keeps only a fraction of the quantity of deposits as reserves...
). From the standpoint of the Fisher equation
Fisher equation
The Fisher equation in financial mathematics and economics estimates the relationship between nominal and real interest rates under inflation....
(see above), there was a concomitant drop both in money supply (credit) and the velocity of money
Velocity of money
300px|thumb|Similar chart showing the velocity of a broader measure of money that covers M2 plus large institutional deposits, M3. The US no longer publishes official M3 measures, so the chart only runs through 2005....
which was so profound that price deflation took hold despite the increases in money supply spurred by the Federal Reserve.
Minor deflations in the US
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...until the permanent abandonment of the gold standard for the Bretton Woods SystemBretton Woods system
The Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states in the mid 20th century...
in 1948. There has only been one period of deflation since, in 2008-9.
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. In late 2008 and early 2009, some economists feared the US could enter a deflationary spiral. Economist Nouriel Roubini
Nouriel Roubini
Nouriel Roubini is an American economist. He claims to have predicted both the collapse of the United States housing market and the worldwide recession which started in 2008. He teaches at New York University's Stern School of Business and is the chairman of Roubini Global Economics, an economic...
predicted that the United States would enter a deflationary recession, and coined the term "stag-deflation" to describe it. It is the opposite of stagflation
Stagflation
In economics, stagflation is a situation in which the inflation rate is high and the economic growth rate slows down and unemployment remains steadily high...
, 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
Colorado
Colorado is a U.S. state that encompasses much of the Rocky Mountains as well as the northeastern portion of the Colorado Plateau and the western edge of the Great Plains...
announced that its state minimum wage
Minimum wage
A minimum wage is the lowest hourly, daily or monthly remuneration that employers may legally pay to workers. Equivalently, it is the lowest wage at which workers may sell their labour. Although minimum wage laws are in effect in a great many jurisdictions, there are differences of opinion about...
, 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.
In the United Kingdom
During World War IWorld War I
World War I , which was predominantly called the World War or the Great War from its occurrence until 1939, and the First World War or World War I thereafter, was a major war centred in Europe that began on 28 July 1914 and lasted until 11 November 1918...
the British
United Kingdom
The United Kingdom of Great Britain and Northern IrelandIn the United Kingdom and Dependencies, other languages have been officially recognised as legitimate autochthonous languages under the European Charter for Regional or Minority Languages...
pound sterling
Pound sterling
The pound sterling , commonly called the pound, is the official currency of the United Kingdom, its Crown Dependencies and the British Overseas Territories of South Georgia and the South Sandwich Islands, British Antarctic Territory and Tristan da Cunha. It is subdivided into 100 pence...
was removed from the gold standard. The motivation for this policy change was to finance World War I; one of the results was inflation, and a rise in the gold price, along with the corresponding drop in international exchange rates for the pound. When the pound was returned to the gold standard after the war it was done on the basis of the pre-war gold price, which, since it was higher than equivalent price in gold, required prices to fall to realign with the higher target value of the pound.
The UK experienced deflation of approx 10% in 1921, 14% in 1922, and 3 to 5% in the early 1930s.
See also
- AgflationAgflationAgflation, a term coined in the late first decade of the 21st century, describes generalised inflation led by rises in Agricultural commodity prices. In the United States, agricultural prices are not generally factored into core inflation figures...
- BiflationBiflationBiflation is a state of the economy where the processes of inflation and deflation occur simultaneously. The term was first introduced by Dr. F. Osborne Brown, a Senior Financial Analyst for the Phoenix Investment Group...
- De-growthDe-growthDegrowth is a political, economic, and social movement based on environmentalist, anti-consumerist and anti-capitalist ideas...
- InflationInflationIn economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
- HyperinflationHyperinflationIn economics, hyperinflation is inflation that is very high or out of control. While the real values of the specific economic items generally stay the same in terms of relatively stable foreign currencies, in hyperinflationary conditions the general price level within a specific economy increases...
- StagflationStagflationIn economics, stagflation is a situation in which the inflation rate is high and the economic growth rate slows down and unemployment remains steadily high...
- Kondratiev waveKondratiev waveKondratiev waves are described as sinusoidal-like cycles in the modern capitalist world economy...
External links
- Cato Policy Report - A Plea for (Mild) Deflation
- Deflation (EH.Net economic historyEconomic historyEconomic history is the study of economies or economic phenomena in the past. Analysis in economic history is undertaken using a combination of historical methods, statistical methods and by applying economic theory to historical situations and institutions...
encyclopedia) - What is deflation and how can it be prevented? (About.com)
- Deflation, Free or Compulsory from Making Economic Sense by Murray N. Rothbard
- Annual Inflation Rate - Japan
- Why Are Japanese Wages So Sluggish? IMF Working paper