Deflation is a persistent fall in some generally followed aggregate indicator of price movements, such as the consumer price index or the GDP deflator. Generally, a one-time fall in the price level does not constitute a deflation. Instead, one has to see continuously falling prices for well over a year before concluding that the economy suffers from deflation. How long the fall has to continue before the public and policy makers conclude that the phenomenon is reflected in expectations of future price developments is open to question. For example, in Japan, which has the distinction of experiencing the longest post World War II period of deflation, it took several years for deflationary expectations to emerge.

In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the annual inflation rate falls below 0% - a negative inflation rate [1]. This should not be confused with disinflation, a slow-down in the inflation rate. Inflation reduces the real value of money over time; conversely, deflation increases the real value of money - the currency of a national or regional economy. This allows one to buy more goods with the same amount of money over time.

Most observers tend to focus on changes in consumer or producer prices since, as far as monetary policy is concerned, central banks are responsible for ensuring some form of price stability, usually defined as inflation rates of +3% or less in much of the industrial world. However, sustained decreases in asset prices, such as for stock market shares or housing, can also pose serious economic problems since, other things equal, such outcomes imply lower wealth and, in turn, reduced consumption spending. While the connection between goods price and asset price inflation or deflation remains a contentious one in the economics profession, policy makers are undoubtedly worried about the existence of a link [2].

2. Causes and corresponding types of deflation

In the Investment and Saving equilibrium and Money Supply equilibrium model, deflation is caused by a shift in the supply-and-demand curve for goods and services, 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. Since these idles the productive 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.

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 [5]. This can produce a liquidity trap. A central bank cannot, normally, charge negative interest for money, and even charging zero interest often produces less simulative 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. A devalued currency produced higher prices for imports without necessarily stimulating exports to a like degree.

In monetarist theory, deflation must be associated with either a reduction in the money supply, a reduction in the velocity of money or an increase in the number of transactions. But any of these may occur separately without deflation. It may be attributed to a dramatic contraction of the money supply, or to adhere to a gold standard or other external monetary base requirement.

However, deflation is the natural condition of hard currency economies when the supply of money is not increased as much as positive population growth and economic growth. When this happens, the available amount of hard currency per person falls, in effect making money scarcer; and consequently, the purchasing power of each unit of currency increases. Deflation occurs when improvements in production efficiency lower the overall price of goods 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.

Rising productivity and reduced transportation cost created structural deflation during the peak productivity era of from 1870-1900, but there was mild inflation for about a decade before the establishment of the Federal Reserve in 1913. There was inflation during World War I, but deflation returned again after that war and during the 1930s depression. Most nations abandoned the gold standard in the 1930s. There is less reason to expect deflation, aside from the collapse of speculative asset classes, under a fiat monetary system with low productivity growth.

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 without an increase in the supply of money, or 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.

Demand-side causes are:

Growth deflation: an enduring decrease in the real cost of goods and services resulting in competitive price cuts.

A structural deflation existed from 1870s until the end of the gold standard in the 1930s based on a decrease in the production and distribution costs of goods. It resulted in competitive price cuts when markets were oversupplied. By contrast, under a fiat monetary system, there was high productivity growth from the end of World War II until the 1960s, but no deflation [6].

Productivity and deflation are discussed in a 1940 study by the Brookings Institution that gives productivity by major US industries from 1919 to 1939, along with real and nominal wages. Persistent deflation was clearly understood as being the result of the enormous gains in productivity of the period [7]. By the late 1920s, most goods were over supplied, which contributed to high unemployment during the Great Depression [8].

Cash building deflation: attempts to save more cash by a reduction in consumption leading to a decrease in velocity of money.

Supply-side causes are:

Bank credit deflation: a decrease in the bank credit supply due to bank failures or increased perceived risk of defaults by private entities or a contraction of the money supply by the central bank.

2.1 Money supply side deflation

From a monetarist perspective, deflation is caused primarily by a reduction in the velocity of money or the amount of money supply per person.

A historical analysis of money velocity and monetary base shows an inverse correlation: for a given percentage decrease in the monetary base the result is nearly equal percentage increase in money velocity [10]. This is to be expected because monetary base (MB), velocity of base money (VB), price level (P) and real output (Y) are related by definition: MB*VB = P*Y. However, it is important to note that the monetary base is a much narrower definition of money than M2 money supply. Additionally, the velocity of the monetary base is interest rate sensitive, the highest velocity being at the highest interest rates [10].

Changes in money supply have historically taken a long time to show up in the price level, with a rule of thumb lag of at least 18 months. Bonds, equities and commodities have been suggested as reservoirs for buffering changes in money supply [13].

2.2 Credit deflation

In modern credit-based economies, a deflationary spiral may be caused by the central bank initiating higher interest rates, thereby possibly popping an asset bubble. 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. The fall in demand causes 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 their 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. 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.

2.3 Scarcity of official money

When structural deflation appeared in the years following 1870, a common explanation given by various government inquiry committees was a scarcity of gold and silver; although they usually mentioned the changes in industry and trade we now call productivity. However, David A. Wells (1890) wells notes that the U. S. money supply during the period 1879-1889 actually rose 60%, the increase being in gold and silver, which rose against the percentage of national bank and legal tender notes. Furthermore, Wells argued that the deflation only lowered the cost of goods that benefited from recent improved methods of manufacturing and transportation. Goods produced by craftsmen did not decrease in price, nor did many services, and the cost of labor actually increased. Also, deflation did not occur in countries that did not have modern manufacturing, transportation and communications [14].

In economies with an unstable currency, barter and other alternate currency arrangements such as dollarization are common, and therefore when the 'official' money becomes scarce, commerce can still continue (e.g., most recently in Zimbabwe). 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. It also acts as a spur to mining and exploration, because one easy way to make money in such an economy is to dig it out of the ground.

3. Effects of deflation

The effects of deflation are:

Decreasing nominal prices for goods and services

Increasing real value of cash money and all monetary items

Discourages bank savings and decreases investment

Enriches creditors at the expenses of debtors

Benefits fixed-income earners

Recessions and unemployment

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, which is similar to taxing currency holders and lenders and using the proceeds to subsidize borrowers. Thus inflation may encourage short term consumption. In modern economies, deflation is usually caused by a drop in aggregate demand, and is associated with recession and more rarely long term economic depressions.

While an increase in the purchasing power of one's money sounds beneficial, it amplifies the sting of debt. This is because 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. 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 US - 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.

In recent times, as loan terms have grown in length and loan financing is common among many types of investments, the costs of deflation to borrowers have grown larger. 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. Consequently deflation 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.

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.

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