When an economy undergoes a deflationary shock, the implications can be both positive and negative for consumers and businesses. There is a big difference between the terms disinflation and deflation, which we will first go over before getting into the causes and effects of deflationary shocks, and how these shocks can affect the economy, consumers and businesses.

SEE: All About Inflation

Disinflation usually occurs during a period of recession and manifests itself by slowing down the rate at which prices increase; this occurs as a result of a decrease in consumer sales. If the inflation rate drops to a lower level than before, technically that difference is disinflation.

Deflation, on the other hand, can be thought of as the opposite of inflation, or as negative inflation, and it occurs when the supply of goods or services rises faster than the supply of money.

Deflation and Its Causes
Deflation manifests itself as a simultaneous sustained contraction or decline in:

  • The general level of prices for goods and services that comprise the consumer basket (consumer price index)
  • Business and consumer credit availability (credit/lending practices)
  • Consumer demand triggered by a decline in the money supply
  • Government spending
  • Business investment spending
  • Investment assets

The precursor or precondition of deflation can be a recessionary period (which can deteriorate to an economic depression), during which there is either an excessive extension of credit or a huge assumption of debt.

Deflation can be triggered by any combination of the following factors:

  • A decline in the money supply
  • An increase in the supply of goods or services, which exacerbate the situation and further lower prices
  • A decrease in the demand for goods
  • An increase in the demand for money

Either an increase in the demand for, or a decrease in the supply of, money will result in people wanting more money, which will result in a higher interest rate (price of money). The increased interest rates will result in decreased demand, as consumers and businesses will reduce borrowing money to make purchases.

If deflation is exacerbated, it can throw an economy into a deflationary spiral. This happens when price decreases lead to lower production levels, which, in turn, leads to lower wages, which leads to lower demand by businesses and consumers, which lead to further decreases in prices. Two sectors of the economy that have traditionally remained well-insulated from economic downturns are education and healthcare as their costs and prices may actually increase while the general level of prices for most goods and services declines.

Money Supply and Deflation
Let's examine the factors and components of deflation, the workings of each and how they impact the economy. We'll start with money supply and lending and credit availability.

The money supply is defined as the total amount of money that is available in an economy at a given time; it includes currency and the various types of deposits offered by banks and other depository institutions. Although money no longer has an intrinsic value, it does have four very valuable functions that facilitate the functioning of an economy and a society: it serves as a medium of exchange, unit of account, store of value and standard of deferred payment.

Types of Credit

Credit, and the extension of credit, is the ability of a debtor to access cash to accomplish goals of a financial or non-financial nature. Credit comes in two different forms and each form works and impacts the debtor differently.

The two types of credit are self-liquidating and the non-self-liquidating credit. Self-liquidating credit is usually a loan needed for the production of (capital) goods or provision of services, and it is for a fairly short to intermediate time period. Due to its nature, the use of such credit generates the financial returns and cash flow that enables the loan repayment and adds value to an economy. The non-self-liquidating type of credit is a loan that is used for the purchase of consumer goods (consumption); it is not tied to the production of goods or services, it relies on other sources of income or cash to be repaid and it tends to stay in the system for a long period of time as it does not generate any income or cash to liquidate itself. This type of lending and credit extension tends to be counterproductive and adds a substantial cost (including opportunity cost) instead of value to an economy, as it tends to burden production.

Lending is based on a dual principle: the willingness of the lender to extend credit and provide funds to consumers and businesses, and the ability of the borrower to repay the loan with interest at a given interest rate based on credit scores and ratings (price of money). Both principles rely on the lenders' and the consumers' confidence in each other, and a positive and upward production trend which enable the debtors to pay back their loan obligations. When that upward growth production trend slows down or stops so does confidence, which impacts the desire to lend and the ability to pay back loans.

Such conditions shift the focus of all participants in an economy from growth to conservation and survival. This translates to creditors becoming more conservative and careful on their lending practices and applications, which leads to a decline in consumer and business spending; this subsequently affects production because the demand for goods and services has declined. The decline in business and consumer spending exerts downward pressure on the prices of goods and services and leads to deflation.

Deflation's Impact on an Economy
What really happens during deflationary shocks? People increase their savings and spend less, especially if they are in fear of losing their jobs or other sources of income. The stock market experiences turbulent fluctuations and indicates a declining trend while at the same time there is a decrease in company buyouts, mergers and hostile takeovers. Governments revise or effect increasingly strict regulation legislations and implement governmental structural changes. As a result of this behavior, investment strategies will switch to less risky and more conservative investment vehicles. In addition, investment strategies will favor tangible investments (real estate, gold/precious metals, collectibles) or short-term investments that tend to maintain their values and provide the consumer with more stable purchasing power.

Macroeconomic Perspective
From a macroeconomic perspective, deflation is caused by a shift in the demand (investment and saving equilibrium) and supply (liquidity preference and money supply equilibrium) curves for final goods and services and a decline in the aggregate demand (gross domestic product), which monetary policy can impact and alter.

When the volume of money and credit transactions decline, relative to the volume of goods and services available, then the relative value of each unit of money rises, making prices of goods fall. In actuality it is the value of money itself that fluctuates and not the value of the goods that is reflected in their prices. The price effects of deflation tend to occur and cut across the board in both goods and investment assets.

Microeconomic Perspective
From a microeconomic perspective, deflation affects two important groups: consumers and businesses.

Impact on the Consumer
These are some of the ways that consumers can preparefor deflation:

  • Pay down or pay off any non self-liquidating debt such as personal loans, credit card loans etc.
  • Increase the amount of savings out of each paycheck
  • Maintain retirement contributions despite stock market fluctuations
  • Seek out bargains and negotiate down for any durable goods that need to be acquired or replaced
  • If there is a feeling of insecurity concerning job continuation and stability or income generating assets, start seeking out alternative sources of income
  • Go back to school or update skills to enhance personal marketability

Impact on Business
The following are some of the ways that a business can prepare for deflation:

  • Develop an action plan that will provide alternatives to any of the business aspects, sectors or costs that will be impacted by deflation
  • Do careful planning on the production of goods and services and inventory reduction
  • Investment planning should focus on higher value goods or services and avoid higher cost/lower value ones
  • Increase investments that will boost productivity and reduce costs
  • Re-evaluate all costs and contractual agreements with clients and suppliers and take appropriate action as necessary

The Bottom Line
Deflation can be beneficial if producers or suppliers can produce more goods at a lower cost, leading to lower prices for consumers. This can be due to either cost-cutting techniques or more efficient production due to improved technology. Deflation can also be perceived as beneficial because it can increase the purchasing power of the currency, which buys more goods and services.

However, deflation can also be harmful to an economy as it forces businesses to cut prices to attract consumers and stimulate the quantity demanded, which has further harmful effects. Deflation also has a harmful effect on borrowers because they must pay back loans in dollars that will buy more goods and services (higher purchasing power) than the dollars they borrowed. Consumers or businesses that procure new loans will raise the real or inflation-adjusted cost of credit, which is the exact opposite effect of what the monetary policy tries to accomplish to combat falling demand. Deflation forces a country's central bank to revalue its monetary unit and readjust its economic and regulatory policies to deal with deflationary shocks.

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