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Economics has enabled us to access a multitude of indicators to measure an economy’s health and stability. As one of the major domains of the social sciences, economics helps us understand how to allocate limited resources in a manner that not only satisfies the needs of all humans but also helps build a sustainable future for all the components of an ecosystem.
In today’s fast-paced world, economics helps us make rational and intelligent decisions by providing numerous indicators with well-defined benchmarks to assist us in achieving a healthy and stabilized economy. These indicators are used by all types of governments, from dictatorial regimes to fully democratic governments. Even private institutions, NGOs, and global organizations use these tools to maximize their desired purposes. These indicators include inflation, poverty, unemployment, share prices, demand, and supply.
1. Deflation: The Indicator of Declining Prices
Deflation is the exact opposite of the often-encountered term inflation, which is widely popular amongst people in general. Inflation is infamous among people for its tendency to increase the prices of daily required commodities, leading to decreased purchasing power (a term used to define the quantity of goods that can be purchased with a single monetary unit).
1.1. How Does Deflation Work?
Deflation is a lesser-known economic term and can be defined as the general decline in prices across a broad range of goods and services in a country. It is also known as “negative inflation.” Considering this definition, you may believe deflation is good, as it allows you to pay less for your daily bread. Well, you’d be wrong! Let’s use an example:
Say country X has entered a phase of deflation. Prices of both consumer and producer goods are lower than before. The residents of country X now spend much less to obtain the goods they require, which causes them to save more money in their pockets. Due to this, the overall amount of money spent in country X decreased compared to the time before the deflation hit. This decrease is known as the decrease in aggregate (total) demand in the economy.
Due to less demand, aggregate supply decreases as producers produce less than usual. Now that they do not have to create as much as before, they start to lay off employees who are no longer required. With the loss of jobs, there is a loss of salary for unemployed people, and they cannot purchase goods to fulfill their needs.
This causes a further decrease in product demand and once again forces the producers to lay off more people, resulting in unemployment and a reduction in demand. This vicious cycle continues and creates a “domino effect” called a “deflationary spiral” in economics.
Since everyone in the country has less money and earnings (producers and consumers), the government also has less to earn from income taxes. People, in general, can no longer afford to pay off their debts, and loan defaults rise. In the long run, this process can severely damage the economy, and the country’s growth will come to a halt.
2. Understanding the Causes of Deflation
Deflation arises from several external and internal factors in that country’s economy. More prominent of these factors include:
2.1. Changes in Government Policy
Several major economic changes, like a significant change in monetary policy, decreasing confidence in the government, or increasing conflicts with other governments (that were trade partners), are the essential reasons for economic problems like deflation.
2.2. Weak Demand
Another common cause of deflation is the weakening of aggregate demand, which occurs when consumers and businesses reduce their spending on goods and services. This happens during periods of recession and heightened uncertainty, like pandemics and wars. Due to this, there is a decrease in total consumption and investment.
2.3. Technological Advancements
Technological progress can contribute to deflationary pressures by increasing productivity at lower production costs. Innovations such as automation, robotics, and artificial intelligence can lead to higher output levels with fewer inputs, which can lead to the loss of jobs for humans and reduce the prices of goods and services.
2.4. Asset Price Deflation
Deflation can also be driven by declines in asset prices, such as stocks, real estate, or commodities, as during the housing market collapse. Such events can erode household wealth and confidence, decreasing consumer spending and investment.
3. What are the Measures of Deflation?
One of the best tools provided to economists to measure both inflation and deflation is the Consumer Price Index or CPI. It measures the average change over a specified period in the prices paid by consumers in any country for a primary market basket of goods of daily use. Economists widely use the CPI in almost all countries to track and monitor changes in the cost of living.
4. Real-world examples of Deflation
4.1. The Great Depression of 1929–1939
The Great Depression is infamous for being one of the most deflationary periods in history. During that time, countries saw a sharp decline in prices across many sectors of the economy. Economic activities contracted, and unemployment peaked, decreasing demand for goods and services, leading to widespread pressures.
4.2. Japan’s Lost Decade of 1990s
Today, one of the most advanced countries in the world, Japan, once experienced a prolonged period of deflation throughout the years ranging from the 1990s to the early 2000s and was widely popular as the “Lost Decade.” It occurred following the burst of Japan’s asset bubble in the late 1980s, and the economy entered a prolonged period of stagnation characterized by falling prices, sluggish growth, and persistently decreasing inflation.
4.3. European Debt Crisis 2010
Several European countries, including Greece, Spain, Portugal, and Ireland, experienced deflationary pressures during the sovereign debt crisis of the early 2010s. The reason was a combination of fiscal imbalances, banking crises, and austerity measures, all leading to a contraction in economic activity and a decline in prices.
4.4. COVID-19 Pandemic 2020-2021
The most recent and familiar to us would be the COVID-19 pandemic of 2020, which put the entire world in lockdown, and associated measures resulted in a loss of demand and deflationary pressures in most countries. Countries reached all-time high unemployment and poverty levels, and businesses ceased to exist. The sudden halt in economic activity led to a collapse in the travel, hospitality, and energy sectors.
5. How Do Governments Address Deflation?
Deflationary pressures often require a holistic approach combining monetary, fiscal, and structural policies. Central banks usually employ expansionary economic policies, such as lowering interest rates, which stimulate businesses to lend and invest, thereby boosting aggregate demand and inflationary pressures.
Governments tend to implement measures such as tax rate cuts and increase government spending, which gives people money and reinforces consumption and investment during these periods. This process of increased government spending is known as ‘helicopter spending.’
The term “Helicopter Money” is a rhetorical term that suggests that governments should print money during deflation and drop it from helicopters to the citizens. This will increase the people’s money, ending the vicious cycle of a deflationary spiral, and production and demand will again gear up. Governments used this method to bring the economy out of the deflationary spiral during the Great Depression, Japan’s Lost Decade, and the COVID-19 pandemic.
6. Take Away
In conclusion, deflation represents a critical economic indicator with profound implications for an economy’s stability and performance. Understanding the causes, effects, measurement, and policy responses to this problem is essential for policymakers, businesses, and individuals. By employing a coordinated and adaptive policy framework, economies can navigate deflationary headwinds and emerge more robust and resilient in economic uncertainty.
Last Updated on by Milan Maity
