Just been covering this area with my AS class and below are some notes. First of all, we need to be clear as to what we mean by deflation. It is a fall in the general price level and must not be confused with falls in a few specific prices, such as for televisions and cars.
Economists distinguish between ‘benign’ deflation and ‘malevolent’ deflation.
‘Benign’ deflation usually stems from technological advances which bring down the price of products. Computer chips would be a good example and I am sure that you can think of others where goods that were initially very expensive have fallen in price as technology has progressed. As a result of the fall in these prices, real incomes have risen.
‘Malevolent’ deflation is the real problem. Here the money supply falls, aggregate demand falls and serious economic consequences may result.
The Consequences of Deflation
1 As aggregate demand falls, firms will find it difficult to sell their products, stocks will begin to rise and less production will be necessary. Firms may try at first to cut costs by wage reductions, but this strategy will be fiercely resisted by workers. The cuts, however, will become inevitable. Even this may not be sufficient and as the demand for goods and services falls, the demand for workers will fall and unemployment in the consumer goods and services industries will rise. The multiplier can work in reverse as well, so an initial fall in spending can trigger further falls in aggregate output.
2 Also, with consumer demand falling, firms will face decreased profits and also have poor expectations of future profitability. There is also a negative accelerator: falling GDP (a recession) hurts business profits, sales, cash flow, use of capacity and expectations. This in turn discourages investment.
3 As firms may have borrowed to invest in capital equipment in the past they will now be faced with the problem that the return on their capital spending is well below what they anticipated. With falling demand but borrowing costs rising in real terms as a result of falling prices, bankruptcies are likely to be a feature of deflation.
4 ‘Negative equity‘ is likely to depress consumer spending as people find that the value of their house falls and their debt or mortgage becomes larger in real terms.
It is the last that could be the real killer. Modern western economies have been built on an ever-rising quantity of debt. In the last decade, borrowers could rely on rising prices to inflate away the real value of their debts; now for the first time since the depression of the 1930s there is the looming threat of debt deflation, where the burden of debt grows bigger rather than smaller. It also means that real interest rates can’t be negative, and so are undesirably high. That spurs yet more repayment of loans so that the liquidation defeats itself.
In terms of policy, the risk of debt deflation will mean that economic policies remain looser for longer and even if inflation remains low and recovery will be hesitant. However if the global economy fails to respond to the stimulus, they don’t have an awful lot left to offer. With deflation there is mention of a classic Keynesian liquidity trap.
The Liquidity Trap
This is a situation where monetary policy becomes ineffective. Cutting the rate of interest is supposed to be the escape route from economic recession: boosting the money supply, increasing demand and thus reducing unemployment. But John Maynard Keynes argued that sometimes cutting the rate of interest, even to zero, would not help. People, banks and firms could become so risk averse that they preferred the liquidity of cash to offering credit or using the credit that is on offer. In such circumstances, the economy would be trapped in recession, despite the best efforts of monetary policy makers.
The graph below shows a liquidity trap. Increases or decreases in the supply of money at an interest rate of X do not affect interest rates, as all wealth-holders believe interest rates have reached the floor.
All increases in money supply are simply taken up in idle balances. Since interest rates do not alter, the level of expenditure in the economy is not affected. Consequently, monetary policy under these circumstances is futile.
Today the threat of deflation seems to have passed us by but the world was looking at a major global slowdown and it was not a matter of how much things were slowing, but it was how much they were going backwards. The most disconcerting fact was that all the easing of interest rates by central banks didn’t really change that outlook. Besides, with the severe threat of deflation there was a need to preserve the firepower in case the economy needed more stimulating. Like when an individual is besieged by many attackers while holding limited ammunition, each shot is used sparingly. But with little ammunition left what was next?