Understanding The Impact of Deflation

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Deflation is understood in economics to be a significant and sustained decline in prices for goods and services. Under deflation, debtors are disadvantaged because their funded loans on real assets lose value, but they must still pay the same first set monetary value.

On the other hand, creditors benefit from deflation as their interest adjusted capital has a higher value than at the beginning.

The purchasing power of consumers grows, the problem with deflation is, not all prices are free and adaptable. With a constant money supply, increases in productivity would directly affect the prices.

Deflation is viewed as connected with risk, since risk-adjusted return on assets tend to dip to negative, as a result investors and buyers stash currency instead of investing in it. In turn, this can have the effect of creating a state of affairs, with the propensity for rearing a liquidity trap.

The actions of the government can induce deflation, for example, if a government decides to cut public spending drastically to reduce the budget deficit or to achieve a budget surplus. This means that the state is less active on the markets, and return with a constant supply to a demand gap.

If there is a downturn in an economic cycle, people are respond cautiously. They expect their incomes to be adversely affected, they fear for their jobs, and therefore anticipate lower future income. And tend to adjust their spending patterns resulting in a so-called consumption strike.

The companies on the other hand, also hold back by switching into cautious gear. They buy only the essentials and embark on very little investment (reluctance to invest). This situation leads to lower sales, business profits and streamlining (often through redundancies). In total, then, the overall demand for goods declines more or less at the same level as the supply of goods (demand gap).

Deflation rears the transfer of wealth from borrowers and holders of illiquid assets, and this tends to benefit savers and bearers of liquid assets and currency. Deflation is most often stimulated by a decline aggregate in demand, and is linked with recession and in some cases long term depressions.

According to monetarist notion, inflation and deflation are always a monetary phenomenon. The underlying reasoning is that a restrictive monetary policy (increase in the reserve or increasing the interest rate) on the quantity equation leads to lower prices.

But even for non-monetarist view a restrictive monetary policy leads to deflation, as it is absorbed for example, by the higher central bank interest aggregate demand.

 

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