Causes and Effects of Deflation
Before going in depth of the economic-, and financial effects of deflation, first the term “deflation” must be defined. Deflation is when consumer and/or producer prices over a period of extended time is going down in the whole economy, not just in certain sectors.
Causes of Deflation
There can be many reasons why a deflation may unfold; however, there are two major ones. The most notable cause is when the consumption supply and demand curve is in a downswing, meaning that people in the country are not buying products and services (most notably durable goods). There are two primary reasons for non-consumption.
The first reason is obvious; people do not have disposable income and savings, that is, they do not have money. People may not have money for a variety of reasons, such as being unemployed for at least a year (unemployment aids are typically paid for only a couple of months, and are enough for meeting the most basic needs).
The other reason for non-consumption is a low consumer spending index, meaning that they are pessimistic about their own financial future
The other major, or common, causes of deflation are low central bank interest rates. Central bank interest rats, in a nutshell, influence inflation by regulating the amount of money circulating in the economy by making loans cheap or expensive (FOR MORE ON THE ROLES OF CENTRAL BANKS AND THEIR INTEREST RATES PLEASE REFER TO THIS ARTICLE (OPENS IN NEW WINDOW)).
Effects of Deflation
Deflation has effects on two main levels; on the corporate-, and on the governmental level.
The most obvious is on the level of companies. By definition, in the event of a deflation, Companies not only cannot raise, but have to actually decrease their prices for their products and services. If they hadn’t decreased their prices, they would go out of business. Although in a deflationary environment, most likely their production costs also decrease, most majority of companies’ profit decrease also, and after a few years they are going to annual losses (there may be companies in sectors with low competition and high profitability ratios, such as utilities, and also companies that have a large portion of profits coming from either foreign operations or from exports). In such scenarios companies cannot plan for and invest in its future growth and development.
When governments want to maintain or increase the real value of their tax income in a deflationary economy, one of three options:
- increase the tax base
- increase tax rates, or a
- combination of the above two
Tax base is the number of people and/or companies that pay taxes. Due to the consumption and corporate environment governments have to be very careful with broadening the tax base, but especially cautious with increasing taxes, as it may cause the economy to sink more deeply into a recession (deflationary economies are also shrinking ones).
- Same wages: as companies cannot afford to increase wages, the nominal value of those wages stays the same (however, their real value increase) not only for the period of deflation, but also for some time during the following stagflationary and inflationary period.
Indirect Effects of Inflation
Deflationary economies have many indirect socio-, political-, financial-, and economical effects. Below you can read a short list of these indirect effects along with a brief description of each:
- Rising unemployment: as companies need to cut cost, they need to fire employees, which are not producing (because they don’t have any work to do).
- Higher government deficits: as most costs stay the same (for political reasons), and some expenditures increase (eg.: rising unemployment aid payments, cost of jumpstarting the economy).
- Recession: no price increase; no economic growth.
- More expensive imports: same foreign currency is worth more domestic currency.
- More income from exports: same foreign currency income is worth more in domestic currency.
More by this Author
Central banks are independent non-commercial banking institutions usually owned by the country in which it operates. Central banking regulations are very strict and specific. These laws ensure that central bank remain...
The Current ratio, also known as cash ratio, or cash asset ratio, or liquidity ratio, is a liquidity type of ratio. Liquidity ratios measure how quickly and easily a company can convert its assets into cash. Obviously...
Share price/Earnings per Share