Deflation is the opposite of the term inflation; deflation is a well-known economic term that is used to describe a period in which the prices of commodities and services fall/decline. Some of the most common causes of deflation include a decrease in:
- Money supply/credit
- Government spending
- Business investment
- High level of unemployment
- Consumer demand
How Deflation Is Counteracted?
To counteract this economic depression, the Fed (Federal Reserve Bank) takes on an active role to stop and prevent severe deflation which can hurt the economy. The central bank devises policies and implements strategies to stop the ever-increasing drop in the prices of goods and services. It is important to do so because persistent decrease in prices can result in many negatives, such as:
- Closing of factories
- Increasing loan defaults
- Falling profits
- Shrinking income and employment
Though the decrease in commodity prices may sound good for consumers, but if it continues for a long term, it can mean that a great recession is underway. This can significantly damage the economy.
To avoid this, the Fed uses expansionary monetary policies to improve and increase the supply of money to stabilize the economy. It lowers the FFR (Fed Funds Rate), uses various tools and strategies to increase money circulation, and even buys treasures through open-market operations. Besides this, discretionary fiscal policies may also be used to offset decreasing prices. This means improving government spending, lowering taxes and even incurring temporary deficits.
The increase in money supply stimulates consumer spending which increases demand for goods/services which further leads to price increase. The increase in prices to some extent is much needed to stabilize the economy. It serves as a lubricant for sustained recovery.
It helps businesses grow their profits and simultaneously reduces depressive pressures.
Deflation – Short-Term or Long-Term
It can be both short term and long term depending on how it is controlled and managed. For example, Japan experienced the longest period of economic deflation that started in the early 90s and lasted for decades.
Further Reading
- Financial stability, deflation, and monetary policy – papers.ssrn.com [PDF]
- The nonlinear economics of debt deflation – books.google.com [PDF]
- Japan's deflation, problems in the financial system and monetary policy – papers.ssrn.com [PDF]
- Deflation and depression: is there an empirical link? – pubs.aeaweb.org [PDF]
- Price deflation and consumption: central bank policy and Japan's economic and financial stagnation – www.sciencedirect.com [PDF]
- Economic crises and the debt-deflation episode in Thailand – www.jstor.org [PDF]
