Deflation

In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below 0% (a negative inflation rate). This should not be confused with, a slow-down in the inflation rate (i.e. when inflation declines to lower levels). Inflation reduces the real value of money over time; conversely, deflation increases the real value of money – the currency of a national or regional economy. This allows one to buy more goods with the same amount of money over time because prices are lower.

Economists generally believe that deflation is a problem in a modern economy because of the danger of a deflationary spiral (explained below). Deflation is correlated with depressions – including the Great Depression, as banks defaulted on depositors. Additionally, deflation may cause the economy to enter a liquidity trap. However, historically not all episodes of deflation correspond with periods of poor economic growth.

Causes and corresponding types
In the (Investment and Saving equilibrium/ Liquidity Preference and Money Supply equilibrium model), deflation is caused by a shift in the supply-and-demand curve for goods and services, particularly a fall in the aggregate level of demand. A capitalist crisis results when surplus value produced by workers but not paid to them has been confiscated by capitalists and low wages and unemployment results in falling demand. That is, there is a fall in how much the whole economy is willing to buy, and the going price for goods. Because the price of goods is falling, consumers have an incentive to delay purchases and consumption until prices fall further, which in turn reduces overall economic activity. Since this idles the productive capacity, investment also falls, leading to further reductions in. This is the deflationary spiral. An answer to falling aggregate demand is stimulus, either from the central bank, by expanding the money supply, or by the fiscal authority to increase demand, and to borrow at interest rates which are below those available to private entities.

In more recent economic thinking, deflation is related to risk: where the risk-adjusted return on assets drops to negative, investors and buyers will hoard currency rather than invest it, even in the most solid of securities. This can produce a liquidity trap. A central bank cannot, normally, charge negative interest for money, and even charging zero interest often produces less stimulative effect than slightly higher rates of interest. In a closed economy, this is because charging zero interest also means having zero return on government securities, or even negative return on short maturities. In an open economy it creates a carry trade, and devalues the currency. A devalued currency produces higher prices for imports without necessarily stimulating exports to a like degree.

In monetarist theory, deflation must be associated with either a reduction in the money supply, a reduction in the velocity of money or an increase in the number of transactions. But any of these may occur separately without deflation. It may be attributed to a dramatic contraction of the money supply, or to adherence to a gold standard or other external monetary base requirement.

However, deflation is the natural condition of hard currency economies when the supply of money is not increased as much as positive population growth and economic growth. When this happens, the available amount of hard currency per person falls, in effect making money more scarce; and consequently, the purchasing power of each unit of currency increases. Deflation occurs when improvements in production efficiency lower the overall price of goods. Competition in the marketplace often prompts those producers to apply at least some portion of these cost savings into reducing the asking price for their goods. When this happens, consumers pay less for those goods; and consequently deflation has occurred, since purchasing power has increased.

Rising productivity and reduced transportation cost created structural deflation during the acceleration productivity era of from 1870–1900, but there was mild inflation for about a decade before the establishment of the Federal Reserve in 1913. There was inflation during World War I, but deflation returned again after that war and during the 1930s depression. Most nations abandoned the gold standard in the 1930s. There is less reason to expect deflation, aside from the collapse of speculative asset classes, under a fiat monetary system with low productivity growth.

In mainstream economics, deflation is considered to be caused by a the relationship of the supply and demand for goods and the supply and demand for money, specifically the supply of money going down and the supply of goods going up. Historic episodes of deflation have often been associated with the supply of goods going up (due to increased productivity) without an increase in the supply of money, or (as with the Great Depression and possibly Japan in the early 1990s) the demand for goods going down combined with a decrease in the money supply. Studies of the Great Depression by have indicated that, in response to decreased demand, the Federal Reserve of the time decreased the money supply, hence contributing to deflation.

Demand-side causes are:
 * Growth deflation: an enduring decrease in the real cost of goods and services resulting in competitive price cuts.
 * A structural deflation existed from 1870s until the end of the gold standard in the 1930s based on a decrease in the production and distribution costs of goods. It resulted in competitive price cuts when markets were oversupplied. By contrast, under a fiat monetary system, there was high productivity growth from the end of World War II until the 1960s, but no deflation.


 * See: Deflation and Long depression.
 * Productivity and deflation are discussed in a 1940 study by the that gives productivity by major US industries from 1919 to 1939, along with real and nominal wages. Persistent deflation was clearly understood as being the result of the enormous gains in productivity of the period.  By the late 1920s, most goods were over supplied, which contributed to high unemployment during the Great Depression.


 * Cash building (hoarding) deflation: attempts to save more cash by a reduction in consumption or investment leading to a decrease in velocity of money.

Supply-side causes are:
 * Bank credit deflation: a decrease in the bank credit supply due to bank failures or increased perceived risk of defaults by private entities or a contraction of the money supply by the central bank.

Money supply side deflation
From a monetarist perspective, deflation is caused primarily by a reduction in the velocity of money and/or the amount of money supply per person.

A historical analysis of money velocity and monetary base shows an inverse correlation: for a given percentage decrease in the monetary base the result is nearly equal percentage increase in money velocity. This is to be expected because monetary base (MB), velocity of base money (VB), price level (P) and real output (Y) are related by definition: MB*VB = P*Y. However, it is important to note that the monetary base is a much narrower definition of money than M2 money supply. Additionally, the velocity of the monetary base is interest rate sensitive, the highest velocity being at the highest interest rates.

Changes in money supply have historically taken a long time to show up in the price level, with a rule of thumb lag of at least 18 months. More recently Alan Greenspan cited the time lag as taking between 12 and 13 quarters. Bonds, equities and commodities have been suggested as reservoirs for buffering changes in money supply.

Credit deflation
In modern credit-based economies, deflation may be caused by the central bank initiating higher interest rates (i.e., to 'control' inflation), thereby possibly popping an asset bubble. In a credit-based economy, a fall in money supply leads to markedly less lending, with a further sharp fall in money supply, and a consequent sharp fall-off in demand for goods. The fall in demand causes a fall in prices as a supply glut develops. This becomes a deflationary spiral when prices fall below the costs of financing production. Businesses, unable to make enough profit no matter how low they set prices, are then liquidated. Banks get assets which have fallen dramatically in value since their mortgage loan was made, and if they sell those assets, they further glut supply, which only exacerbates the situation. To slow or halt the deflationary spiral, banks will often withhold collecting on non-performing loans (as in Japan, most recently). This is often no more than a stop-gap measure, because they must then restrict credit, since they do not have money to lend, which further reduces demand, and so on.

Historical examples of credit deflation
This cycle has been traced out on the broad scale during the Great Depression. Partly because of overcapacity and market saturation and partly as a result of the Smoot-Hawley Tariff Act, international trade contracted sharply, severely reducing demand for goods, thereby idling a great deal of capacity, and setting off a string of bank failures. A similar situation in Japan, beginning with the stock and real estate market collapse in the early 1990s, was arrested by the Japanese government preventing the collapse of most banks and taking over direct control of several in the worst condition. These occurrences are the matter of intense debate.

Scarcity of official money
When structural deflation appeared in the years following 1870, a common explanation given by various government inquiry committees was a scarcity of gold and silver, although they usually mentioned the changes in industry and trade we now call productivity. However, (1890) notes that the U. S. money supply during the period 1879-1889 actually rose 60%, the increase being in gold and silver, which rose against the percentage of national bank and legal tender notes. Furthermore, Wells argued that the deflation only lowered the cost of goods that benefited from recent improved methods of manufacturing and transportation. Goods produced by craftsmen did not decrease in price, nor did many services, and the cost of labor actually increased. Also, deflation did not occur in countries that did not have modern manufacturing, transportation and communications.

In economies with an unstable currency, barter and other alternate currency arrangements such as dollarization are common, and therefore when the 'official' money becomes scarce (or unusually unreliable), commerce can still continue (e.g., most recently in Zimbabwe). Since in such economies the central government is often unable, even if it were willing, to adequately control the internal economy, there is no pressing need for individuals to acquire official currency except to pay for imported goods. In effect, barter acts as a protective tariff in such economies, encouraging local consumption of local production. It also acts as a spur to mining and exploration, because one easy way to make money in such an economy is to dig it out of the ground.

Effects
The effects of deflation are:
 * 1) Decreasing nominal prices for goods and services
 * 2) Increasing real value of cash money and all assets denominated in cash terms
 * 3) May decrease investment if cash holdings are seen as preferable
 * 4) May encourage bank savings in preference to other forms of investment
 * 5) Benefits creditors at the expenses of debtors
 * 6) Benefits recipients of fixed incomes
 * 7) Recessions and unemployment (disputed)

Deflation is generally regarded negatively, as it causes a transfer of wealth from borrowers and holders of illiquid assets, to the benefit of savers and of holders of liquid assets and currency. In this sense it is the opposite of the more usual scenario of inflation, whose effect is to tax currency holders and lenders (savers) and use the proceeds to subsidize borrowers, including governments. (These inflationary benefits for non-government borrowers are often negated by banks who charge higher interest rates to compensate for predictable inflationary benefits.) Thus inflation encourages short term consumption and can similarly over stimulate investment in projects that may not be worthwhile in real terms (for example the housing or dot.com bubbles). In modern economies, deflation is usually caused by a drop in aggregate demand, and is associated with recession and (more rarely) long term economic depression.

While an increase in the purchasing power of one's money benefits some, it amplifies the sting of debt for others: after a period of deflation, the payments to service a debt represent a larger amount of purchasing power than they did when the debt was first incurred. Consequently, deflation can be thought of as an effective increase in a loan's interest rate. If, as during the Great Depression in the United States, deflation averages 10% per year, even an interest-free loan is unattractive as it must be repaid with money worth 10% more each year. Under normal conditions, the Fed and most other central banks implement policy by setting a target for a short-term interest rate &mdash; the overnight federal funds rate in the US &mdash; and enforcing that target by buying and selling securities in open capital markets. When the short-term interest rate hits zero, the central bank can no longer ease policy by lowering its usual interest-rate target. With interest rates near zero, debt relief becomes an increasingly important tool in managing deflation.

In recent times, as loan terms have grown in length and loan financing (or leveraging) is common among many types of investments, the costs of deflation to lenders has grown larger. Deflation can discourage private investment, because there is reduced expectations on future profits when future prices are lower. Consequently with reduced private investments, spiraling deflation can cause a collapse in aggregate demand. Without the "hidden risk of inflation", it may become more prudent for institutions to hold on to money, and not to spend or invest it (burying money).

and in banking, advocates argue that if the money supply were grown without the use of debt, then deflation would be a welcome effect. For the lowering of prices increases. And improvement of increases the total output of an economy.

Since deflationary periods favor those who hold currency over those who do not, they are often matched with periods of rising populist sentiment, as in the late 19th century, when populists in the US wanted debt relief or to move off the gold standard and onto a silver or bimetal standard because the supply of silver was increasing relatively faster than the supply of gold (making silver inflationary—or less deflationary—compared to gold).

Deflationary spiral
A deflationary spiral is a situation where decreases in price lead to lower production, which in turn leads to lower wages and demand, which leads to further decreases in price. Since reductions in general price level are called deflation, a deflationary spiral is when reductions in price lead to a vicious circle, where a problem exacerbates its own cause. The Great Depression was regarded by some as a deflationary spiral. A deflationary spiral is the modern macroeconomic version of the general glut controversy of the 19th century. Another related idea is 's theory that excess debt can cause a continuing deflation. Whether deflationary spirals can actually occur is controversial, with its possibility being disputed by freshwater economists (including the ) and economists.

Counteracting deflation
During severe deflation, targeting an interest rate (the usual method of determining how much money to create) may be ineffective, because even lowering the short-term interest rate to zero may result in a real interest rate which is too high to attract credit-worthy borrowers. Thus the central bank must directly set a target for the quantity of money (called "") and may use extraordinary methods to increase the supply of money, e.g. purchasing financial assets of a type not usually used by the central bank as reserves (such as ). As the current of the United States Federal Reserve System,, said in 2002, "...sufficient injections of money will ultimately always reverse a deflation."

Until the 1930s, it was commonly believed by that deflation would cure itself. As prices decreased, demand would naturally increase and the economic system would correct itself without outside intervention.

This view was challenged in the 1930s during the Great Depression. Advocates of s argued that the economic system was not self-correcting with respect to deflation and that governments and central banks had to take active measures to boost demand through tax cuts or increases in government spending. Reserve requirements from the central bank were high compared to recent times. So were it not for redemption of currency for gold (in accordance with the gold standard), the central bank could have effectively increased money supply by simply reducing the reserve requirements and through (e.g., buying treasury bonds for cash) to offset the reduction of money supply in the private sectors due to the collapse of credit (credit is a form of money).

With the rise of monetarist ideas, the focus in fighting deflation was put on expanding demand by lowering interest rates (i.e., reducing the "cost" of money). This view has received a setback in light of the failure of accommodative policies in both Japan and the US to spur demand after stock market shocks in the early 1990s and in 2000–2002, respectively. worry about the inflationary impact of monetary policies on asset prices. Sustained low real rates can cause higher asset prices and excessive debt accumulation. Therefore, lowering rates may prove to be only a temporary palliative, aggravating an eventual debt deflation crisis.

With interest rates near zero, debt relief becomes an increasingly important tool in managing deflation.

Special borrowing arrangements
When the central bank has lowered nominal interest rates to zero, it can no longer further stimulate demand by lowering interest rates. This is the famous liquidity trap. When deflation takes hold, it requires "special arrangements" to lend money at a zero nominal rate of interest (which could still be a very high real rate of interest, due to the negative inflation rate) in order to artificially increase the money supply.

In Hong Kong
Following the Asian financial crisis in late 1997, Hong Kong experienced a long period of deflation which did not end until the 4th quarter of 2004. Many East Asian currencies devalued following the crisis. The however, was pegged to the, leading to an adjustment instead by a deflation of consumer prices. The situation was worsened by the increasingly cheap exports from Mainland China, and weak consumer confidence in Hong Kong. This deflation was accompanied by an economic slump that was more severe and prolonged than those of the surrounding countries that devalued their currencies in the wake of the Asian financial crisis.

In Ireland
In February 2009, Ireland's announced that during January 2009, the country experienced deflation, with prices falling by 0.1% from the same time in 2008. This is the first time deflation has hit the Irish economy since 1960. Overall consumer prices decreased by 1.7% in the month.

Brian Lenihan, Ireland's Minister for Finance, mentioned deflation in an interview with RTÉ Radio. According to RTÉ's account, "Minister for Finance Brian Lenihan has said that deflation must be taken into account when Budget cuts in child benefit, public sector pay and professional fees are being considered. Mr Lenihan said month-on-month there has been a 6.6% decline in the cost of living this year."

This interview is notable in that the deflation referred to is not discernibly regarded negatively by the Minister in the interview. The Minister mentions the deflation as an item of data helpful to the arguments for a cut in certain benefits. The alleged economic harm caused by deflation is not alluded to or mentioned by this member of government. This is a notable example of deflation in the modern era being discussed by a senior financial Minister without any mention of how it might be avoided, or whether it should be.

In Japan
Deflation started in the early 1990s. The Bank of Japan and the government tried to eliminate it by reducing interest rates and 'quantitative easing', but did not create a sustained increase in broad money and deflation persisted. In July 2006, the zero-rate policy was ended.

Systemic reasons for deflation in Japan can be said to include:


 * Tight monetary conditions. The Bank of Japan has kept monetary policy loose only when inflation has been below zero, tightening whenever deflation ends.


 * Unfavorable demographics. Japan has an aging population (22.6% over age 65) that is not growing and will soon start a long decline.  The Japanese death rate recently exceeded the birth rate.


 * Fallen asset prices. In the case of Japan asset price deflation was a mean reversion or correction back to the price level that prevailed before the asset bubble. There was a rather large price bubble in equities and especially real estate in Japan in the 1980s (peaking in late 1989).


 * Insolvent companies: Banks lent to companies and individuals that invested in real estate. When real estate values dropped, these loans could not be paid. The banks could try to collect on the collateral (land), but this wouldn't pay off the loan. Banks delayed that decision, hoping asset prices would improve. These delays were allowed by national banking regulators. Some banks made even more loans to these companies that are used to service the debt they already had. This continuing process is known as maintaining an "unrealized loss", and until the assets are completely revalued and/or sold off (and the loss realized), it will continue to be a deflationary force in the economy. Improving bankruptcy law, land transfer law, and tax law have been suggested (by ) as methods to speed this process and thus end the deflation.


 * Insolvent banks: Banks with a larger percentage of their loans which are "non-performing", that is to say, they are not receiving payments on them, but have not yet written them off, cannot lend more money; they must increase their cash reserves to cover the bad loans.


 * Fear of insolvent banks: Japanese people are afraid that banks will collapse so they prefer to buy (United States or Japanese) Treasury bonds instead of saving their money in a bank account. This likewise means the money is not available for lending and therefore economic growth. This means that the savings rate depresses consumption, but does not appear in the economy in an efficient form to spur new investment. People also save by owning real estate, further slowing growth, since it inflates land prices.


 * Imported deflation: Japan imports Chinese and other countries' inexpensive consumable goods (due to lower wages and fast growth in those countries) and inexpensive raw materials, many of which reached all time real price minimums in the early 2000s. Thus, prices of imported products are decreasing. Domestic producers must match these prices in order to remain competitive. This decreases prices for many things in the economy, and thus is deflationary.

In November 2009 Japan returned to deflation, according to the. reports that consumer prices fell in October 2009 by a near record 2.2%.

Major deflations in the US
There have been three significant periods of deflation in the United States.

The first was the recession of the late 1830s, following the Panic of 1837, when the currency in the United States contracted by about 30%, a contraction which is only matched by the Great Depression. This "deflation" satisfies both definitions, that of a decrease in prices and a decrease in the available quantity of money.

The second was after the, sometimes called The Great Deflation. It was possibly spurred by return to a gold standard, retiring paper money printed during the Civil War. "'The Great Sag of 1873-96 could be near the top of the list. Its scope was global. It featured cost-cutting and productivity-enhancing technologies. It flummoxed the experts with its persistence, and it resisted attempts by politicians to understand it, let alone reverse it. It delivered a generation’s worth of rising bond prices, as well as the usual losses to unwary creditors via defaults and early calls. Between 1875 and 1896, according to, prices fell in the United States by 1.7% a year, and in Britain by 0.8% a year."


 * (Note: (1890) gives an account of the period and discusses the great advances in productivity. The productivity gains matched the deflation.

The third was between 1930–1933 when the rate of deflation was approximately 10 percent/year, part of the United States' slide into the Great Depression, where banks failed and unemployment peaked at 25%.

The deflation of the Great Depression, as in 1836, did not begin because of any sudden rise or surplus in output. It occurred because there was an enormous contraction of credit (money), bankruptcies creating an environment where cash was in frantic demand, and the Federal Reserve did not adequately accommodate that demand, so banks toppled one-by-one (because they were unable to meet the sudden demand for cash— see ). From the standpoint of the (see above), there was a concomitant drop both in money supply (credit) and the velocity of money which was so profound that price deflation took hold despite the increases in money supply spurred by the Federal Reserve.

Minor deflations in the US
Throughout the history of the United States, inflation has approached zero and dipped below for short periods of time (negative inflation is deflation). This was quite common in the 19th century and in the 20th century before World War II.

Some economists believe the United States may be currently experiencing deflation as part of the Financial crisis of 2007–2010; compare the theory of debt-deflation. Year-on-year, consumer prices dropped for six months in a row to end-August 2009, largely due to a steep decline in energy prices. Consumer prices dropped 1 percent in October, 2008. This was the largest one-month fall in prices in the US since at least 1947. That record was again broken in November, 2008 with a 1.7% decline. In response, the decided to continue cutting interest rates, down to a near-zero range as of December 16, 2008. In late 2008 and early 2009, some economists feared the US could enter a deflationary spiral. Economist predicted that the United States would enter a deflationary recession, and coined the term "stag-deflation" to describe it. It is the opposite of, which was the main fear during the spring and summer of 2008. The United States then began experiencing measurable deflation, steadily decreasing from the first measured deflation of -0.38% in March, to July's deflation rate of -2.10%. On the wage front, in October 2009 the state of Colorado announced that its state minimum wage, which is indexed to inflation, is set to be cut, which would be the first time a state has cut its minimum wage since 1938.

In the United Kingdom
During World War I the British was removed from the gold standard. The motivation for this policy change was to finance World War I; one of the results was inflation, and a rise in the gold price, along with the corresponding drop in international exchange rates for the pound. When the pound was returned to the gold standard after the war it was done on the basis of the pre-war gold price, which, since it was higher than equivalent price in gold, required prices to fall to realign with the higher target value of the pound.

The UK experienced deflation of approx 10% in 1921, 14% in 1922, and 3 to 5% in the early 1930s.