In economics, deflation is an increase in the real value of the monetary unit of account, as reflected in a decrease in the general price level of goods and services exchanged, measurable by broad price indices.Robert J. Barro and Vittorio Grilli (1994), European Macroeconomics, chap. 8, p. 142.
Deflation is a monetary phenomenon, explainable in terms of changes in money supply and velocity relative to spending on output. "It is monetary in the sense that the sustained growth in some monetary aggregate relative to the trend growth of real output (adjusted for the trend in velocity) determines the rate of change in the price level."
Deflation is distinct from disinflation, a slowdown in the inflation rate; i.e., when inflation declines to a lower rate but is still positive. Deflation occurs when the inflation rate falls below 0% and becomes negative. While inflation reduces the value of currency over time, deflation increases it. This allows more goods and services to be bought than before with the same amount of currency, but means that more goods or services must be sold for money in order to finance payments that remain fixed in nominal terms, as many debt obligations may.
Economists generally believe that a larger deflationary shock is a problem in a modern economy because it increases the real value of debt, especially if the deflation is unexpected. Parts of the financial sector that finance lending by borrowing currency or short-term funds can be stressed as the short-term cost of funds rise above the return available from simply holding money during a deflation. Deflation may also aggravate recessions and lead to a deflationary spiral.
Causes and corresponding types
In the IS–LM model (investment and saving equilibriumliquidity preference and money supply equilibrium model), deflation is caused by a shift in the supply and demand curve for goods and services. This in turn can be caused by an increase in supply, a fall in demand, or both.
When prices are falling, consumers have an incentive to delay purchases and consumption until prices fall further, which in turn reduces overall economic activity. When purchases are delayed, productive capacity is idled and investment falls, leading to further reductions in aggregate demand. This is the deflationary spiral. The way to reverse this quickly would be to introduce an economic stimulus. The government could increase productive spending on things like infrastructure or the central bank could start expanding the money supply.
Deflation is also related to risk aversion, where investors and buyers will start hoarding money because its value is now increasing over time. This can produce a liquidity trap or it may lead to shortages that entice investments yielding more jobs and commodity production. 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.
Deflation is the natural condition of economies when the supply of money is fixed, or does not grow as quickly as population and the economy. 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 also 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 accelerated productivity era from 1870 to 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 the war and during the 1930s depression. Most nations abandoned the gold standard in the 1930s so that 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.
Causes include, on the demand side: Growth deflation Hoarding
And on the supply side: Bank credit deflation Debt deflation Decision on the money supply side Credit deflation
Growth deflation Growth deflation is an enduring decrease in the real cost of goods and services as the result of technological progress, accompanied by competitive price cuts, resulting in an increase in aggregate demand.
A structural deflation existed from the 1870s until the cycle upswing that started in 1895. The deflation was caused by the decrease in the production and distribution costs of goods. It resulted in competitive price cuts when markets were oversupplied. The mild inflation after 1895 was attributed to the increase in gold supply that had been occurring for decades. There was a sharp rise in prices during World War I, but deflation returned at the war's end. By contrast, under a fiat monetary system, there was high productivity growth from the end of World War II until the 1960s, but no deflation.
Historically not all episodes of deflation correspond with periods of poor economic growth.Andrew Atkeson and Patrick J. Kehoe of the Federal Reserve Bank of Minneapolis Deflation and Depression: Is There an Empirical Link?
Productivity and deflation are discussed in a 1940 study by the Brookings Institution that gives productivity by major US industries from 1919 to 1939, along with real and nominal wages. Persistent deflation was clearly understood as being the result of the enormous gains in productivity of the period. By the late 1920s, most goods were over supplied, which contributed to high unemployment during the Great Depression.
Bank credit deflation Bank credit deflation is 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.Carapella, Francesca (2015). "Banking panics and deflation in dynamic general equilibrium". Finance and Economics Discussion Series 2015-018. Washington: Board of Governors of the Federal Reserve System. .
Debt deflation
Debt deflation is a phenomenon associated with the end of long-term credit cycles. It was proposed as a theory by Irving Fisher (1933) to explain the deflation of the Great Depression.
Money supply-side deflation From a monetarist perspective, deflation is caused primarily by a reduction in the velocity of money or the amount of money supply per person.
A historical analysis of money velocity and monetary base shows an inverse correlation: for a given percentage decrease in the monetary base the result is a nearly equal percentage increase in money velocity. This is to be expected because monetary base (, velocity of base money (, price level () and real output () are related by definition: . However, 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.
In the early history of the United States, there was no national currency and an insufficient supply of coinage. Banknotes were the majority of the money in circulation. During financial crises, many banks failed and their notes became worthless. Also, banknotes were discounted relative to gold and silver, the discount depended on the financial strength of the bank.
In recent years changes in the 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.Greenspan interview on CNBC, 3 December 2010 Bonds, equities and commodities have been suggested as reservoirs for buffering changes in the 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 slow-down or fall in lending leads to less money in circulation, with a further sharp fall in money supply as confidence reduces and velocity weakens, with a consequent sharp fall-off in demand for employment or goods. The fall in demand causes a fall in prices as a supply glut develops. This becomes a deflationary spiral when prices fall below the costs of financing production, or repaying debt levels incurred at the prior price level. Businesses, unable to make enough profit no matter how low they set prices, are then liquidated. Banks get assets that 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, and most recently America and Spain). 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 In the early economic history of the United States, cycles of inflation and deflation correlated with capital flows between regions, with money being loaned from the financial center in the Northeast to the commodity producing regions of the (mid)-West and South. In a procyclical manner, prices of commodities rose when capital was flowing in, that is, when banks were willing to lend, and fell in the depression years of 1818 and 1839 when banks called in loans. Also, there was no national paper currency at the time and there was a scarcity of coins. Most money circulated as banknotes, which typically sold at a discount according to distance from the issuing bank and the bank's perceived financial strength.