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In economics, deflation is a decrease in the general price level of goods and services.^[1] Deflation occurs when the annual inflation rate falls below zero percent (a negative inflation rate), resulting in an increase in the real value of money – allowing one to buy more goods with the same amount of money. This should not be confused with disinflation, a slow-down in the inflation rate (i.e. when inflation decreases, but still remains positive).^[2] As inflation reduces the real value of money over time, conversely, deflation increases the real value of money – the functional currency (and monetary unit of account) in a national or regional economy.

Currently, mainstream economists generally believe that deflation is a problem in a modern economy because of the danger of a deflationary spiral (explained below).^[3] Deflation is also linked with recessions and with the Great Depression. Additionally, deflation also prevents monetary policy from stabilizing the economy because of a mechanism called the liquidity trap. However, historically not all episodes of deflation correspond with periods of poor economic growth.^[4]

Contents 1 Classical term 2 Effects of deflation 3 Deflationary spiral 4 Causes of deflation 5 Counteracting deflation 6 Examples of deflation 6.1 United Kingdom 6.2 Deflation in the United States 6.2.1 Major deflations 6.2.2 Minor deflations 6.3 Deflation in Hong Kong 6.4 Deflation in Japan 6.5 Deflation in Ireland 7 See also 8 References 9 External links

[edit] Classical term

The term "deflation" was used with an alternative meaning by the classical economists, to refer to a decrease in the money supply and credit; some economists, including many Austrian-school economists, still use the word in this sense.^[5] The two meanings are related, since a decrease in the money supply (assuming the velocity of money is unchanged) is likely to cause a decrease in the general price level.

[edit] Effects of deflation

In economics, deflation refers to a general reduction in the level of prices below zero percent year-on-year inflation. Deflation should not be confused with a temporary fall in prices; instead, it is a sustained fall in prices that occurs when the inflation rate passes down below zero percent (0%).

In the IS/LM model (that is, the Income and Saving equilibrium/ Liquidity Preference and Money Supply equilibrium model), deflation is caused by a shift in the supply and demand curve for goods and interest, particularly a fall in the aggregate level of demand. That is, there is a fall in how much the whole economy is willing to buy, and the going price for goods. Because the price of goods is falling, consumers have an incentive to delay purchases and consumption until prices fall further, which in turn reduces overall economic activity - contributing to the deflationary spiral.

Since this idles capacity, investment also falls, leading to further reductions in aggregate demand. This is the deflationary spiral. An answer to falling aggregate demand is stimulus, either from the central bank, by expanding the money supply, or by the fiscal authority to increase demand, and to borrow at interest rates which are below those available to private entities.

A different view is that deflation increases sales and economic activity by making essentials (food, housing, fuel etc.) which cannot be delayed, more affordable to struggling consumers, thereby reducing severity and duration of recession.

Inflation has the opposite effect and thus frequently precedes recessions. For example, prices of these essentials sky-rocketed before the recession of 2008.

In more recent economic thinking, deflation is related to risk:  where the risk-adjusted return on assets drops to negative, investors and buyers will hoard currency rather than invest it, even in the most solid of securities. This can produce the theoretical condition, much debated as to its practical possibility, of a liquidity trap. A central bank cannot, normally, charge negative interest for money, and even charging zero interest often produces less stimulative effect than slightly higher rates of interest. In a closed economy, this is because charging zero interest also means having zero return on government securities, or even negative return on short maturities. In an open economy it creates a carry trade, and devalues the currency producing higher prices for imports without necessarily stimulating exports to a like degree.

In monetarist theory, deflation is related to a sustained reduction in the velocity of money or number of transactions. This is attributed to a dramatic contraction of the money supply, perhaps in response to a falling exchange rate, or to adhere to a gold standard or other external monetary base requirement.

Deflation is generally regarded negatively, as it causes a transfer of wealth from borrowers and holders of illiquid assets, to the benefit of savers and of holders of liquid assets and currency. In this sense it is the opposite of inflation (or in the extreme, hyperinflation), which is a tax on currency holders and lenders (savers) in favor of borrowers and short term consumption. In modern economies, deflation is caused by a collapse in demand (usually brought on by high interest rates), and is associated with recession and (more rarely) long term economic depressions.

In modern economies, as loan terms have grown in length and loan financing (or leveraging) is common among all sorts of investments, the penalties associated with deflation have grown larger. Since deflation discourages investment and spending, because there is no reason to risk on future profits when the expectation of profits may be negative and the expectation of future prices is lower, it generally leads to, or is associated with a collapse in aggregate demand. Without the "hidden risk of inflation", it may become more prudent just to hold on to money, and not to spend or invest it.

Deflation is, however, the natural condition of hard currency economies when the rate of increase in the supply of money is not maintained at a rate commensurate to positive population (and general economic) growth. When this happens, the available amount of hard currency per person falls, in effect making money more scarce; and consequently, the purchasing power of each unit of currency increases. The late 19th century provides an example of sustained deflation combined with economic development under these conditions.

Deflation also occurs when improvements in production efficiency lower the overall price of goods. Improvements in production efficiency generally happen because economic producers of goods and services are motivated by a promise of increased profit margins, resulting from the production improvements that they make. Competition in the marketplace often prompts those producers to apply at least some portion of these cost savings into reducing the asking price for their goods. When this happens, consumers pay less for those goods; and consequently deflation has occurred, since purchasing power has increased.

While an increase in the purchasing power of one's money sounds beneficial, it can actually cause hardship when the majority of one's net worth is held in illiquid assets such as homes, land, and other forms of private property. It also amplifies the sting of debt, since—after some period of significant deflation—the payments one is making in the service of a debt represent a larger amount of purchasing power than they did when the debt was first incurred. Consequently, deflation can be thought of as a phantom amplification of a loan's interest rate. If, as during the Great Depression in the United States, deflation averages 10% per year, even a 0% loan is unattractive as it must be repaid with money worth 10% more each year. Since

Under normal conditions, the Fed and most other central banks implement policy by setting a target for a short-term interest rate--the overnight federal funds rate in the United States--and enforcing that target by buying and selling securities in open capital markets. When the short-term interest rate hits zero, the central bank can no longer ease policy by lowering its usual interest-rate target.,

the usual methods of regulating the money supply may be ineffective, as even lowering the short-term interest rate to zero may result in a "real" interest rate which is rather high; thus other mechanisms must be brought into play to increase the supply of money such as purchasing assets or quantitative easing (printing money). As the current Chairman of the United States Federal Reserve, Ben Bernanke, said in 2002, "...sufficient injections of money will ultimately always reverse a deflation."^[6]

Hard money advocates argue that if there were no "rigidities" in an economy, then deflation should be a welcome effect, as the lowering of prices would allow more of the economy's effort to be moved to other areas of activity, thus increasing the total output of the economy. This theory has been criticized by some economists, who note that if there were no rigidities, neither inflation nor deflation would have a significant effect.

Since deflationary periods favor those who hold currency over those who do not, they are often matched with periods of rising populist sentiment, as in the late 19th century, when populists in the United States wanted to move off hard money standards and back to a money standard based on the more inflationary (because more abundantly available) metal silver.

[edit] Deflationary spiral

A deflationary spiral is a situation where decreases in price lead to lower production, which in turn leads to lower wages and demand, which leads to further decreases in price.^[7] Since reductions in general price level are called deflation, a deflationary spiral is when reductions in price lead to a vicious circle, where a problem exacerbates its own cause. The Great Depression was regarded by some as a deflationary spiral. Whether deflationary spirals can actually occur is controversial.

A deflationary spiral is the modern macroeconomic version of the general glut controversy of the 19th century. Another related idea is Irving Fisher's theory that excess debt can cause a continuing deflation.

[edit] Causes of deflation

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In mainstream economics, deflation may be caused by a combination of the supply and demand for goods and the supply and demand for money, specifically the supply of money going down and the supply of goods going up. Historic episodes of deflation have often been associated with the supply of goods going up (due to increased productivity) without an increase in the supply of money, or (as with the Great Depression and possibly Japan in the early 1990s) the demand for goods going down combined with a decrease in the money supply. Studies of the Great Depression by Ben Bernanke have indicated that, in response to decreased demand, the Federal Reserve of the time decreased the money supply, hence contributing to deflation.

From a monetarist perspective deflation is caused primarily by a reduction in the velocity of money and/or the amount of money supply per person.^{[citation needed]}

In modern credit-based economies, a deflationary spiral may be caused by the (central bank) initiating higher interest rates (i.e., to 'control' inflation), thereby possibly popping an asset bubble or the collapse of a command economy which has been run at a higher level of production than it could actually support. In a credit-based economy, a fall in money supply leads to markedly less lending, with a further sharp fall in money supply, and a consequent sharp fall-off in demand for goods. Demand falls, and with the falling of demand, there is a fall in prices as a supply glut develops. This becomes a deflationary spiral when prices fall below the costs of financing production. Businesses, unable to make enough profit no matter how low they set prices, are then liquidated. Banks get assets which have fallen dramatically in value since the (mortgage) loan was made, and if they sell those assets, they further glut supply, which only exacerbates the situation. To slow or halt the deflationary spiral, banks will often withhold collecting on non-performing loans (as in Japan, most recently). This is often no more than a stop-gap measure, because they must then restrict credit, since they do not have money to lend, which further reduces demand, and so on.

In unstable currency economies, barter and other alternate currency arrangements such as dollarization are common, and therefore when the 'official' money becomes scarce (or unusually unreliable), commerce can still continue (e.g., most recently in Russia and Argentina).^{[citation needed]} Since in such economies the central government is often unable, even if it were willing, to adequately control the internal economy, there is no pressing need for individuals to acquire official currency except to pay for imported goods. In effect, barter acts as protective tariff in such economies, encouraging local consumption of local production.^{[citation needed]} It also acts as a spur to mining and exploration, since one easy way to make money in such an economy is to dig it out of the ground.

When the central bank has lowered nominal interest rates all the way to zero, it can no longer further stimulate demand by lowering interest rates. This is the famous liquidity trap. When deflation takes hold, it requires "special arrangements" to "lend" money at a zero nominal rate of interest (which could still be a very high real rate of interest, due to the negative inflation rate) in order to (artificially) increase the money supply.

This cycle has been traced out on the broad scale during the Great Depression. International trade contracted sharply, severely reducing demand for goods, thereby idling a great deal of capacity, and setting off a string of bank failures. A similar situation in Japan, beginning with the stock and real estate market collapse in the early 1990s, was arrested by the Japanese government preventing the collapse of most banks and taking over direct control of several in the worst condition. These occurrences are the matter of intense debate. There are economists who argue that the post-2000 recession had a period where the US was at risk of severe deflation, and that therefore the Federal Reserve central bank was right in holding interest rates at an "accommodative" stance from 2001 on.

[edit] Counteracting deflation

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Until the 1930s, it was commonly believed by economists that deflation would cure itself. As prices decreased, demand would naturally increase and the economic system would correct itself without outside intervention.

This view was challenged in the 1930s during the Great Depression. Keynesian economists argued that the economic system was not self-correcting with respect to deflation and that governments and central banks had to take active measures to boost demand through tax cuts or increases in government spending. Reserve requirements from the central bank were high and the central bank could then have effectively increased money supply by simply reducing the reserve requirements and through "open" market operations (e.g., buying treasury bonds for cash) to offset the reduction of money supply in the private sectors due to the collapse of credit (credit is a form of money).

With the rise of monetarist ideas, the focus in fighting deflation was put on expanding demand by lowering interest rates (i.e., reducing the "cost" of money). This view has received a setback in light of the failure of accommodative policies in both Japan and the US to spur demand after stock market shocks in the early 1990s and in 2000–2002, respectively. Economists now worry about the (inflationary) impact of monetary policies on asset prices. Sustained low real rates can be the direct cause of higher asset prices and excessive debt accumulation. Therefore lowering rates may prove only a temporary palliative, leading to the aggravation of an eventual future debt deflation crisis.

[edit] Examples of deflation

[edit] United Kingdom

During World War I the British pound sterling was removed from the gold standard. The motivation for this policy change was to finance World War I; one of the results was inflation, and a rise in the gold price, along with the corresponding drop in international exchange rates for the pound. When the pound was returned to the gold standard after the war it was done on the basis of the pre-war gold price, which, since it was higher than equivalent price in gold, required prices to fall to realign with the higher target value of the pound.

The UK experienced deflation of approx 10% in 1921, 14% in 1922, and 3 to 5% in the early 1930s.^[8]

[edit] Deflation in the United States

[edit] Major deflations

There have been three significant periods of deflation in the United States.

The first was the recession of 1836, when the currency in the United States contracted by about 30%, a contraction which is only matched by the Great Depression. This "deflation" satisfies both definitions, that of a decrease in prices and a decrease in the available quantity of money.

The second was after the Civil War, sometimes called The Great Deflation. It was possibly spurred by return to a gold standard, retiring paper money printed during the Civil War.

"The Great Sag of 1873-96 could be near the top of the list. Its scope was global. It featured cost-cutting and productivity-enhancing technologies. It flummoxed the experts with its persistence, and it resisted attempts by politicians to understand it, let alone reverse it. It delivered a generation’s worth of rising bond prices, as well as the usual losses to unwary creditors via defaults and early calls. Between 1875 and 1896, according to Milton Friedman, prices fell in the United States by 1.7% a year, and in Britain by 0.8% a year. [2]

The third was between 1930–1933 when the rate of deflation was approximately 10 percent/year, part of the United States slide into the Great Depression, where banks failed and unemployment peaked at 25%.

The deflation of the Great Depression, as in 1836, did not begin because of any sudden rise or surplus in output. It occurred because there was an enormous contraction of credit (money), bankruptcies creating an environment where cash was in frantic demand, and the Federal Reserve did not adequately accommodate that demand, so banks toppled one-by-one (because they were unable to meet the sudden demand for cash— see Fractional-reserve banking). From the standpoint of the Fisher equation (see above), there was a concomitant drop both in money supply (credit) and the velocity of money which was so profound that price deflation took hold despite the increases in money supply spurred by the Federal Reserve.

[edit] Minor deflations

Throughout the history of the United States, inflation has approached zero and dipped below for short periods of time (negative inflation is deflation). This was quite common in the 19th century and in the 20th century before World War II.

Some economists believe the United States may be currently experiencing deflation as part of the financial crisis of 2007–2009; compare the theory of debt-deflation. Year-on-year, consumer prices dropped for six months in a row to end-August 2009, largely due to a steep decline in energy prices. Consumer prices dropped 1 percent in October, 2008. This was the largest one-month fall in prices in the US since at least 1947. That record was again broken in November, 2008 with a 1.7% decline. In response, the Federal Reserve decided to continue cutting interest rates, down to a near-zero range as of December 16, 2008.^[9] In late 2008 and early 2009, some economists feared the US could enter a deflationary spiral.^{[citation needed]} Economist Nouriel Roubini predicted that the United States would enter a deflationary recession, and coined the term "stag-deflation" to describe it.^[10] It is the opposite of stagflation, which was the main fear during the spring and summer of 2008. The United States then began experiencing measurable deflation, steadily decreasing from the first measured deflation of -0.38% in March, to July's deflation rate of -2.10%. On the wage front, in October 2009 the state of Colorado announced that its state minimum wage, which is indexed to inflation, is set to be cut, which would be the first time a state has cut its minimum wage since 1938.^[11]

[edit] Deflation in Hong Kong

Following the Asian financial crisis in late 1997, Hong Kong experienced a long period of deflation which did not end until the 4th quarter of 2004 [3]. Many East Asian currencies devalued following the crisis. The Hong Kong dollar, however, was pegged to the US Dollar. The gap was filled by deflation of consumer prices. The situation is worsened with cheap commodity goods from Mainland China, and weak consumer confidence. According to Guinness World Records, Hong Kong was the economy with lowest inflation in 2003. [4]

[edit] Deflation in Japan

Deflation started in the early 1990s. The Bank of Japan and the government have tried to eliminate it by reducing interest rates (part of their 'quantitative easing' policy), but this was unsuccessful for over a decade. In July 2006, the zero-rate policy was ended.

Systemic reasons for deflation in Japan can be said to include:

• Fallen asset prices. There was a rather large price bubble in both equities and real estate in Japan in the 1980s (peaking in late 1989). When assets decrease in value, the money supply shrinks, which is deflationary.

• Insolvent companies:  Banks lent to companies and individuals that invested in real estate. When real estate values dropped, these loans could not be paid. The banks could try to collect on the collateral (land), but this wouldn't pay off the loan. Banks have delayed that decision, hoping asset prices would improve. These delays were allowed by national banking regulators. Some banks make even more loans to these companies that are used to service the debt they already have. This continuing process is known as maintaining an "unrealized loss", and until the assets are completely revalued and/or sold off (and the loss realized), it will continue to be a deflationary force in the economy. Improving bankruptcy law, land transfer law, and tax law have been suggested (by The Economist) as methods to speed this process and thus end the deflation.

• Insolvent banks:  Banks with a larger percentage of their loans which are "non-performing", that is to say, they are not receiving payments on them, but have not yet written them off, cannot lend more money; they must increase their cash reserves to cover the bad loans.

• Fear of insolvent banks:  Japanese people are afraid that banks will collapse so they prefer to buy gold or (United States or Japanese) Treasury bonds instead of saving their money in a bank account. This likewise means the money is not available for lending and therefore economic growth. This means that the savings rate depresses consumption, but does not appear in the economy in an efficient form to spur new investment. People also save by owning real estate, further slowing growth, since it inflates land prices.

• Imported deflation: Japan imports Chinese and other countries' inexpensive consumable goods, raw materials (due to lower wages and fast growth in those countries). Thus, prices of imported products are decreasing. Domestic producers must match these prices in order to remain competitive. This decreases prices for many things in the economy, and thus is deflationary.

In November 2009 Japan has returned to deflation, according to the Wall Street Journal.

[edit] Deflation in Ireland

In February 2009, Ireland's Central Statistics Office announced that during January 2009, the country experienced deflation, with prices falling by 0.1% from the same time in 2008. This is the first time deflation has hit the Irish economy since 1960. Overall consumer prices decreased by 1.7% in the month.^[12]

Brian Lenihan, Ireland's Minister for Finance, mentioned deflation in an interview with RTÉ Radio. According to RTÉ's account, "Minister for Finance Brian Lenihan has said that deflation must be taken into account when Budget cuts in child benefit, public sector pay and professional fees are being considered. Mr Lenihan said month-on-month there has been a 6.6% decline in the cost of living this year."

This interview is notable in that the deflation referred to is not discernibly regarded negatively by the Minister in the interview. The Minister mentions the deflation as an item of data helpful to the arguments for a cut in certain benefits. The alleged economic harm caused by deflation is not alluded to or mentioned by this member of government. This is a notable example of deflation in the modern era being discussed by a senior financial Minister without any mention of how it might be avoided, or whether it should be. ^[13]

[edit] See also

• Inflation
• Hyperinflation
• Macroeconomics
• Stagflation
• De-growth

[edit] References

This article includes a list of references or external links, but its sources remain unclear because it has insufficient inline citations. Please help to improve this article by introducing more precise citations where appropriate. (January 2009)

• Ben S. Bernanke. Deflation: Making Sure "It" Doesn't Happen Here. USA Federal Reserve Board. 2002-11-21. Accessed: 2008-10-17. (Archived by WebCite at http://www.webcitation.org/5bdTTiZhU)
• Michael Bordo & Andrew Filardo, Deflation and monetary policy in a historical perspective: Remembering the past or being condemned to repeat it?, In: Economic Policy, October 2005, pp 799–844.
• Georg Erber, The Risk of Deflation in Germany and the Monetary Policy of the ECB. In: Cesifo Forum 4 (2003), 3, pp 24–29
• Charles Goodhart and Boris Hofmann, Deflation, credit and asset prices, In: Deflation - Current and Historical Perspectives, eds. Richard C. K. Burdekin & Pierre L. Siklos, Cambridge University Press, Cambridge, 2004.
• International Monetary Fund, Deflation: Determinants, Risks, and Policy Options - Findings of an Independent Task Force, Washington D. C., April 30, 2003.
• International Monetary Fund, World Economic Outlook 2006 - Globalization and Inflation, Washington D. C., April 2006.
• Otmar Issing, The euro after four years: is there a risk of deflation?, 16th European Finance Convention, 2 December 2002, London, Europäische Zentralbank, Frankfurt am Main
• Paul Krugman, Its Baaaaack: Japan's Slump and the Return of the Liquidity Trap, In: Brookings Papers on Economic Activity 2, (1998), pp 137–205
• Steven B. Kamin, Mario Marazzi & John W. Schindler, Is China "Exporting Deflation"?, International Finance Discussion Papers No. 791, Board of Governors of the Federal Reserve System, Washington D. C. January 2004.

[edit] External links

• Wiktionary:Deflation
• Cato Policy Report - A Plea for (Mild) Deflation
• Deflation (EH.Net economic history encyclopedia)
• What is deflation and how can it be prevented? (About.com)
• Deflation, Free or Compulsory from Making Economic Sense by Murray N. Rothbard
• Annual Inflation Rate - Japan