Deflation – definition, causes and effects

Deflation is one of the common phrases when analysing the economic situation. So what is deflation? The causes and effects in the economy and the relationship between deflation and recession will be introduced clearly in this following article!

What is deflation?

Deflation is defined as a general decrease in prices for goods and services. It occurs naturally when the inflation rate falls below 0%, based on the money supply of a stable economy. Deflation is mentioned a lot in economic analysis, but what is deflation is a question many people are still wondering about.

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During a deflationary period, the purchasing power of money and wages is higher than before. In fact, deflation make the nominal expenditures of labour, capital, goods, and services lower if there are no contraction in the money supply.

See also: What is remittances? How to transfer remittances

What are the causes of deflation?

There are many causes of deflation, but the two main factors are a decrease in aggregate demand and an increase in productivity.

A decrease in aggregate demand

When the quantity of demand having finacially viable for final goods falls, resulting in prices being pushed down because of spending cuts, the stock market will fail.

Therefore consumers who want to increase savings, monetary policies will be tightened, leading to higher interest rates.

Increase productivity

Advances in science and technology make companies operate more efficiently. At that time, production costs will be reduced, leading to the benefit of consumers because the selling prices of products will be lower.

What are the effects of deflation?

Deflation causes many effects to the market in particular and to the economy in general. This includes both positive and negative influences.

Negative influence

Deflation will make economic activities go through a period of stagnation as many consumers wait for deeper discounts, businesses delay investment and recruitment to save costs, specifically:

Interest rate

The interest rate shows the current consumer price relative to the future consumer price. Prolonged deflation leads to low interest rates.

When output stagnates and declines, real interest rates rise, causing a widening recession. Monetary policy will lose its effect if the recession is prolonged and deflation persists.

Labor value, money value and commodity value

Deflation takes place causing prices to fall, the currency is more valuable, so investors will keep money and reduce spending. Workers’ wages have been reduced because many businesses have to adjust to compensate for the damage caused by deflation.

Debt defaults, unemployment, bankruptcy, reduced profits, etc. are negative outcomes caused by deflation.

Positive effect

Although deflation causes many negative effects, seriously affecting the economy, deflation also has some positive effects. Because deflation is based on new technology, productivity and output will increase as the economy grows rapidly.

Deflation creates an open business environment, preventing forms of monopoly as much as possible. Thereby creating a free market to help improve competitive efficiency, make the most of resources and help consumers receive great benefits.

Solutions to crack deflation

By understanding what is deflation, with the negative effects that deflation brings, how to fight against deflation? Some anti-deflation solutions should be noted as follows:

  • Applying reasonable fiscal and monetary policies to promptly handle deflation.
  • Maintaining a buffer zone by keeping the safe inflation rate below 10%, do not bring inflation to zero.
  • Loosening monetary policy, focusing on private investment, keeping the economy’s financial stability.
  • Promoting the activities of the business sector by stimulating the market, increasing public spending.
  • Increasing sales tax.

The link between recession and deflation

Recession and deflation are closely related.

Deflation occurs during and after economic recession. Specifically, when an economy experiences a severe crisis or recession, economic output will be slowed down due to reduced investment and consumption demand.

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Deflation leads to a fall in asset prices, whereby manufacturers are forced to liquidate inventories. Consumers and investors begin to stockpile money as a precaution against increased financial risks.

The increased saving tendency will cause the daily expenditure to decrease, and aggregate demand will decrease. This will lower people’s expectations for future inflation and save money again.

See also: What is Recession? The cause of the economic recession

Conclusion

The above article has helped you answer the question of what deflation is as well as provide some important information about deflation to provide you with the most complete and in-depth knowledge. See you in the next topic!

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