Deflation
What is Deflation?
Deflation is a sustained fall in the general price level of an economy, measured as a negative annual percent change in a price index such as the CPI.
Deflation is a rare and unusual economic phenomenon where there is a sustained decrease in the general price level of goods and services in an economy over a period of time. It is measured as an annual percentage decrease in the CPI. Deflation can be caused by various factors, including a decrease in the money supply, a decrease in aggregate demand, and improvements in productivity. Deflation can have negative effects on the economy, such as reducing spending and investment, and increasing the burden of debt.
Deflation: a worked example
A country's consumer price index falls from 120.0 to 117.6 over one year. The inflation rate is (117.6 minus 120.0) divided by 120.0, times 100, which equals negative 2 percent, so the economy is in deflation. Now trace what that does to a borrower. A shop owner took out a loan at a nominal interest rate of 1 percent. Using the approximation real rate equals nominal rate minus inflation, the real interest rate is 1 minus negative 2, which is 3 percent. The stated 1 percent loan actually costs three times that in purchasing power, because the dollars repaid buy more goods than the dollars borrowed did. Meanwhile the shop's revenue falls with prices while its loan payment stays fixed in dollars, which is the mechanism that makes deflation dangerous for debtors.
The mistake students make with deflation
The sign of the inflation term trips people up in the real interest rate formula. Seeing negative 2 percent inflation, students write 1 minus 2 and answer negative 1 percent, when the correct move is 1 minus negative 2, or 3 percent. Deflation raises the real cost of borrowing, it does not lower it. A quick sanity check: if prices are falling, each dollar handed back to the lender buys more than the dollar that was received, so the true burden must exceed the sticker rate.
Deflation questions
Is deflation good for consumers?
Deflation looks good on a shopping trip and bad everywhere else. Falling prices raise the purchasing power of a fixed nominal wage, but they also cut business revenue, which pressures firms to cut wages and lay off workers. Shoppers who expect further price drops delay purchases, weakening aggregate demand and pushing prices down again. Anyone holding debt repays in dollars worth more than the ones borrowed. Most economists treat sustained deflation as a warning sign rather than a bargain.
What causes deflation?
Deflation comes from either a collapse in aggregate demand or a large increase in aggregate supply. A sharp fall in consumption, investment, or the money supply shifts aggregate demand left, lowering both the price level and real output, which is the harmful version. A productivity boom or a drop in input costs shifts short-run aggregate supply right, lowering the price level while output rises, which is the benign version. Reading which curve moved tells you whether falling prices signal trouble.
Why can a central bank struggle to fight deflation?
Nominal interest rates cannot fall far below zero, which is the zero lower bound problem. Suppose deflation runs at negative 2 percent and the central bank drives the nominal rate to zero. The real interest rate is still 0 minus negative 2, or positive 2 percent, which may be too high to revive borrowing. Deflation therefore keeps real rates elevated exactly when the economy needs them low, and conventional monetary policy runs out of room.
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