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Deflation is an economic phenomena in which the price level falls. It can also be thought of as the value of a currency appreciating over time. Economists generally agree that deflation is not a good thing, and should be avoided.
Deflation is a sustained fall in the price level, often the result in a fall in the supply of money, so a very brief dip in prices that lasts only one or two months is not considered deflation. If the price of some goods or services falls that also isn't deflation, cheaper computers may be a result of changes in supply and demand. The overall price level must fall. Deflation has often come with economic hard times, so outside of a few cranks most economists and finance experts would prefer to avoid it. Throughout modern history deflation was more normal until fairly recently, with the rise of inflation targeting central banks.
Why is deflation considered bad?
Like inflation, deflation can have very real negative impacts on an economy. The Great Depression saw a major bout of deflation as did some previous 19th century depressions.[note 1] Major reasons to avoid deflation include the following:
- Labor markets: Inflation helps keep labor markets functioning more smoothly. If the price level falls and pay checks have to be cut workers will fight it. Falling income also means that other workers will simply have to be fired, reducing total output and snowballing the economic contraction. Unionized workers go on strike, while non-unionized workers may threaten to unionize, sabotage the work place, or shirk on job duties. People may become organized politically and fight for higher minimum wages as well. If nominal wages fall, even in perfect lockstep with the price level, most people simply see this as bad and resist it. If nominal wages rise, even if they don't rise as fast as the price level, they are in effect taking pay cuts but they tend not to care. By maintaining a slow and steady rate of inflation a central bank can keep unemployment down and ensure nominal wage growth even during a recession. Real wages may take a slight hit, but there is less labor unrest.
- Monetary policy: Steady-state inflation tends to mean a higher steady-state short-term interest rate. In the presence of a contraction or recession, this gives a central bank more "room to maneuver". That is, it can cut interest rates and combat the recession because the interest rates are high enough to be cut. Deflation brings down both real and nominal rates.
- Debtors and financial markets: Suppose a farmer has a yearly income of $10,000 and an annual debt obligation of $1,000. If his income falls by 5% his new income is now $9,500. His nominal debt payments are the same, but they are now a greater share of his income.[note 2] On a macro level, this is like a cut to aggregate demand if it happens to large numbers of people. Overall, deflation is bad for financial markets as deflation can increase the real interest rate in harmful ways. The real interest rate (r) is calculated by subtracting the rate of inflation(p) from the nominal interest rate (R).[note 3]
- Hoarding: Deflationary spirals encourage hoarding of cash because a dollar today will be worth more tomorrow if one just holds on to it, why bother investing it in productive activities?
When can deflation be a good thing?
Under some circumstances deflation can be positive. If gains in productivity and/or competition slowly lower the price level, then this is good for consumers. Essentially deflation is very bad when it comes from the demand side. Supply-side deflation can, however, be just fine. From 1800 to 1900 the United States saw a gradual decline in the overall price level. While both inflation and bad deflation occurred in between those dates the fact that prices very slowly fell was not an issue. Per capita GDP and real wages both grew over the century. The 1920s saw a similar pattern, economic growth with a slight decline in the price level. However, because good deflation can easily slip into bad deflation, especially at the precipice of an economic contraction, economists are generally hesitant about targeting a deflation rate instead of a very low inflation rate.[note 4]
- Austrian school of economists, who think that deflation is good
- Bitcoin, which was designed to become increasingly scarce over time, and is hence deflationary
- Gold Standard
- ↑ Major ones being the Long Depression of 1873-1879 and the Depression of 1893-1894.
- ↑ Deflation means falling prices, which also means that property values fall, so the farmer can't sell his farm to pay off his mortgage if it is now worth less in nominal terms than for what he owes.
- ↑ Because deflation is just negative inflation that means you are subtracting a negative (i.e., adding). So a 2% nominal interest rate and a 4% rate of deflation mean a real interest rate of 6%. At best, banks might benefit from deflation in the very short run by lending at higher real rates but if more people fail to repay debts, or simply refuse to borrow it will be bad for lenders as well.
- ↑ Most economists and central bankers in developed nations agree that the ideal inflation target should be around 1-3%, with 2% a frequently cited ideal. Some mainstream economists, although a minority, do favor a 0% inflation target.
- ↑ Chappelow, Jim. "Deflation". Investopedia. Retrieved 2020-02-04.
- ↑ "Deflation Is Always Good for the Economy". Mises Institute. Retrieved 2020-02-04.
- ↑ Hayes, Adam. "Why Is Deflation Bad for the Economy?". Investopedia. Retrieved 2020-02-04.
- ↑ Coibion, O., Gorodnichenko, Y., & Wieland, J. (2012). The optimal inflation rate in New Keynesian models: should central banks raise their inflation targets in light of the zero lower bound?. Review of Economic Studies, 79(4), 1371-1406.