Deflation is often considered a highly unfavorable phenomenon, however there are different types of deflation that have different implications. In other words, the effects of deflation depend to a large extent on the particular context…This article distinguishes between good deflation and bad deflation.
Good deflation is generally caused by a positive supply shock (i.e. an outward shift of the supply curve) that leads to the production of higher quantities sold at lower prices. In most cases, this type of deflation can be attributed to technological progress. New technologies allow companies to improve their production processes and reduce costs. As a result, the price level falls and (relatively speaking) money becomes more valuable.
An example of good deflation is the development of flat screen televisions. When they were introduced a few years ago, not many people could afford to buy one, because they were quite expensive ($3,000 – $4,000). However, due to technological progress and improved production processes, a flat screen television only costs about $600 – $1,000 these days…
Bad deflation is caused by a negative demand shock (i.e. an inward shift of the demand curve) that leads to the consumption of lower quantities at lower prices. In other words, sellers have to reduce prices, because there is a lack of demand and they cannot sell their goods at the original price anymore. This is problematic in several ways:
- When prices fall, people tend to postpone purchase decisions because they expect prices to fall even more. That can lead to a vicious circle, since postponed purchases result in lower demand which in turn drives prices further down.
- The burden of debts increases, as the price level decreases. That is, if you were to borrow money today, the amount you would have to pay back in a year would be worth more. Admittedly, lenders profit from this situation. However, since they usually only spend a portion of the additional income, the economy will experience an additional decrease in overall spending (and thus the vicious circle mentioned above will be amplified).
- As a result of the lower revenue, companies will have to reduce costs. Because of sticky nominal wages (i.e. the fact that wages cannot be lowered without provoking resistance), they will have to let people go, thereby causing an increase in unemployment.
The example above illustrates why those forms of deflation are considered “bad”. At a first glance it may look like consumers are better off. However, there are significant negative effects on suppliers that will eventually affect consumers as well. This form of deflation is especially problematic, because of the self-amplifying nature of the process that can ultimately lead to a deflationary trap.
In a nutshell:
- Bad deflation causes a vicious circle, because
- people postpone purchase decisions,
- the burden of debt increases, and
- unemployment rises due to sticky nominal wages.
- Good deflation, on the other hand,
- is mainly based on technological progress and can actually be beneficial for both consumers and producers.
In conclusion, it can be said that deflation may be bad, but it does not necessarily have to be.
[The above article is presented by Lorimer Wilson, editor of www.munKNEE.com and the FREE Market Intelligence Report newsletter (sample here) and may have been edited ([ ]), abridged (…) and/or reformatted (some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. The author’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article. This paragraph must be included in any article re-posting to avoid copyright infringement.]
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