Monday, November 19, 2012

Deflation vs Inflation

Source: US Bureau of Labor statistics (showing deflation in early 1920s and 1930s)

In the MPC's last monthly inflation report they forecast that inflation could fall to 1%. They even hinted at the possibility of deflation. What is deflation and why does it strike fear into economists and policy makers?


Deflation is simply a fall in the general price level. If this deflation a result of improved productivity and greater efficiency, it could be benign. But, usually deflation is caused by falling demand and lower growth. It is no coincidence that our worst period of deflation was in the great depression of the 1930s. This kind of deflation is very damaging because:
  1. Lower Spending. When prices are falling, there is an incentive to delay purchases. Why buy a TV now, when it will be cheaper in 12 months? Look at how the housing market is suffering because of falling prices. Nobody wants to buy with falling house prices; this is why property transactions have slumped and of course causes further falls in prices. In Japan, the decade of deflation created a culture of thrift and saving. Japanese housewives just wouldn't spend. Tax cuts, government spending and interest rate cuts all failed to stimulate growth because all the Japanese wanted to do was save (an example, of the Paradox of thrift)
  2. Liquidity Trap. A liquidity trap occurs when lower interest rates fail to stimulate spending. If prices are falling by 2%, it can be more attractive to save money in cash then spend. Therefore, cutting interest rates to 0% may be ineffective in increasing demand.
  3. Increasing Burden of Debt. If you take out a mortgage and make mortgage payments of say £500 a month, inflation will progressively reduce the real value of your mortgage interest payments. High inflation thus makes a mortgage more attractive, over time, it increases the disposable income of mortgage owners.
  • However, with deflation, this £500 a month becomes a bigger % of your disposable income. In deflation, debt becomes an increasing burden reducing spending and economic growth.
  • The problem is that the UK and US are increasingly indebted, personal savings are very low. Personal debt is very high therefore, deflation would be very damaging for an economy burdened with a legacy of debt.
  • 4. Rising Real Wages. Workers will general seek to prevent a cut in nominal wages. Therefore, with deflation, real wages rise by stealth. This can lead to real wage unemployment. With deflation, it is much more difficult for prices and wages to adjust.

How To Overcome Deflation.

Basically, Monetary authorities need to implement bold policies. In particular they need to increase inflationary expectations. The problem is Central banks are so used to trying to reduce inflationary expectations, that they can struggle to implement the opposite. However, the experience of Japan in the 1990s and 2000s suggests timid policies can lead to several years of economic stagnation.


Anonymous said...

Well, there should be a stagnation because in the recent years there haven't been any production increase. It's just the increase of consumer sector and that's only a way to redistribute the money.
People should insure their savings and try not to consume much.

hughdc said...

The article suggests in a period of deflation a mortgage repayment becomes a greater percentage of discretionary income. Why? If disposable income remains constant and high street prices are dropping and the mortgage repayment is constant then surely assuming you keep your job, more disposable income becomes available to spend if a consumer is motivated to do so. The mortgage repayment continues to be the same percentage or less, not more.

hughdc said...

Assuming a total disposable income of £1000 and mortgage repayments of £500 i.e. 50%.In a period of deflation with prices dropping the mortgage repayment remains at 50% of disposable income and the remaining 50% is available to make more discretionary purchases - if a consumer is motivated to so do. Why therefore is it claimed that in a period of deflation the mortgage repayment represents a greater percentage of disposable income?

Anonymous said...

Hughdc----to answer your question, it is because your salary or wage will be reduced commensurate with price drops. Companies cannot keep paying wages that were supported in an inflationary economy by continual rises. Now, you will get annual reviews and instead of getting a % increase, you will get a % decrease. Isn't that motivating? :)

Tejvan Pettinger said...

thanks anonymous.

Generally deflation increases the debt burden. Because wages fall, but debt stays the same

Sandeep Malviya said...

This article is really helpful to understand the Deflation and Inflation too. All things as usual work on old phenomenon on Demand and Supply.

Sandeep, Realty Expert @

sid1138 said...

Deflation is only bad from the point of view of a borrower who can't refinance. Deflation is great for those who lend, those on a fixed income, and those with a job. (Note that the biggest borrowers are the various governments, and they are the ones saying deflation is bad.) Deflation is no worse than inflation - both indicate problems in the economy.

The good thing about inflation is that interest rates fall, allowing businesses to invest cheaply in new equipment. This makes businesses more efficient and therefore able to make money with decreasing prices. When inflation comes back, their efficiencies make them even more profitable and able to grow quickly, taking advantage of their efficiencies.

What should really happen is inflationary periods should be followed by deflationary periods. This would allow lenders and borrowers to both benefit and long price stability would help everyone to plan. Instead, central banks, like the US Fed, aim for 2-3% inflation a year to help the governments manage their debt. The problem is that level of inflation indicates a long-term weakness in the economy, and a long term inflation (US prices are over 10 times higher than in the 1940's). This level of inflation increases the chance of bubbles and the associated economic disasters they cause.