Is Deflation Really Bad for the Economy?

The word deflation has an extremely negative connotation in economic circles. Modern day economists portray deflation as the situation which needs to be avoided at all costs. Central banks often create policies in such a manner that they try to avoid deflation. All these steps lead one to assume that it is a given fact that deflation is bad for the economy. In reality, this is not really the case, and deflation is not such an obvious villain. Economic history is rife with periods where “good deflation” has created significant benefits for everyone involved.

In this article, we will understand what good deflation is and how it affects the overall economy.

The Theory about Deflation

Before we understand why deflation can be good for the economy, we need to understand why it is considered to be bad for the economy. The circular flow of money concept is at the root of the defamation of deflation. The idea is that every dollar which is spent by one person ends up becoming the income of another person. Hence, if fewer dollars are spent by people, the income of other people is reduced. In turn, they spend even fewer dollars, and the consumption in the overall economy goes down. This is driven by two things. Firstly, all participants are afraid that their income might reduce in the future. Secondly, all participants expect the prices of goods to reduce in the future.

Modern economists believe that deflation, if not controlled, will lead to a vicious cycle which will end up damaging the economy.

Can Deflation be Beneficial?

It is a myth that falling prices destroy an economy. There are many industries which have continued to flourish and grow at astounding rates in an atmosphere of falling prices. For instance, the computers and associated equipment industries have rapidly increased their sales volume even though their prices have been falling year on year. The same is the case with electronic goods like television, refrigerators and so on. Their prices have also been decreasing in real terms for many years now. This means that even though their prices have remained the same, the quality of these products has improved. Hence, their real prices have dropped over time.

Deflation has not only worked for industries. It has worked for entire countries as well. For instance, the economy of Japan was in deflation for six years. However, during that same period, it made significant economic progress

When can Deflation be Good?

The reality is that deflation, by itself, is not a negative thing. It can be good for the economy depending upon several other conditions. These conditions have also been listed in this article.

  • Good deflation is when the rise in productivity is not passed on to the employees. Instead, it is passed on to the consumers. This means that even if the efficiency of the employees' increases, their wages do not increase. This reduces the overall cost of production. These lower costs enable companies to sell goods at a lower price and still make the same profit! Also, the employment is not reduced as the overall spending is not cut. Hence, people are not afraid of job losses, the spending is not cut, and the general economy is not decimated.
  • Sustained deflation can work for products where people buy based on their requirements. Purchasing and selling are not driven by speculative behaviour. Hence, the anticipation of a future fall in prices does not deter the buyer from making a purchase now. This behaviour can be seen in the cell phone and laptop industries. Every year, these products become cheaper than the previous year. However, every year, the sales are not affected. This is because customers tend to buy these products when they need them and not based on expectations of future price increases.
  • Deflation is only good if the industry is being driven by rapid technological advances. There is a limit to how much human productivity can increase in any given year. For deflation to be significant and sustained, productivity has to increase very rapidly. This is only possible with technological intervention. This is the reason that all industries where price reduction is the norm are technology intensive.

However, as mentioned above, in scenarios where good deflation is prevailing, employees do not get regular pay hikes. This should not be a problem since the inflation in the market is not increasing. Instead, the prices of products are falling. Hence, even though the wages appear to remain constant in nominal terms, they are actually increasing in real terms.

The problem with deflation is that such a culture is difficult to enforce. Employees have become used to pay hikes, and inflation has become the norm! Now, when they do not receive nominal hikes, employees tend to become restless. This is despite the fact that their income might actually be increasing in real terms.

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Managerial Economics