Deflation

Defined as a sustained fall in the general level of prices, deflation is not necessarily harmful, but there there is a danger that it could have disastrous economic consequences.

The causes of deflation

Deflation is in almost all cases a side effect of a collapse of aggregate demand--a drop in spending so severe that producers must cut prices in order to find buyers.The economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending--namely, recession, rising unemployment, and financial stress.

The effects of deflation

First-round effects

Deflation tends to make consumers reduce their purchases in the expectation of being able to buy more cheaply at a later date. That can have a depressing effect upon demand and lead to a reduction of output. Another potentially important effect is to require borrowers to repay more than they had borrowed (for example, if prices declined by 20 percent, a farmer who had previously borrowed £100 to buy ten pigs would have to repay the equivalent of twelve pigs). The resulting loss to borrowers may be balanced by gains to lenders, but if borrowers are forced to default, the resulting disruption can lead to a further reduction in output. Another effect is to require employers to pay their employees the same wages despite a reduction in income from their employees' output. Unless there is a compensating wage reduction, that may result in a reduction in employment and another reduction in output.

Second-round effects : the "deflationary spiral"

A sudden and unexpected deflation can result in output losses that feed upon themselves by reinforcing the tendencies that produced them. For example the output loss from the deferrment of purchases could lead to an increase in unemployment, which could prompt a further reduction in spending and thus a further increase in unemployment.

Policy responses

Central bank policy makers generally, recommend early preemptive action to avert the danger of deflation - on the grounds that it is difficult to devise effective policies to counter it once it has taken hold. Their principle precautionary weapon is a rapid relaxation of monetary policy by reductions in interest rates . Most of them also advocate supplementing monetary action with short-term fiscal measures, especially when interest rates approach zero and the liquidity trap renders conventional monetary policy ineffective . To deal with severe threats of deflation they also advocate supplementing interest rate cuts with direct action to increase the money supply by "printing money" (otherwise known as "quantitative easing"). They recognise, however, that such remedies can be costly and difficult to manage. Delay is likely to reduce their effectiveness, but hurriedly-devised public expenditure projects are apt to be uneconomic. The intention would be to remove the stimulus once it had served it purpose, but public awareness of that intention could reduce its effectiveness (a quandary that prompted the economist Paul Krugman to suggest that "the way to make monetary policy effective, then, is for the central bank to credibly promise to be irresponsible" ). On the other hand, failure to reverse policy as recovery commences, creates a danger of inflation. Thus the decision to launch anti-deflation measures involves a balancing of risks, and their success depends upon accurate diagnosis and rapid response to change.

Historical experience

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