Thursday, June 10, 2010

Falling prices in macro and micro economics

Readers Question on Deflation and falling prices of goods
When prices are falling, consumers tend to delay purchasing. Rather than buy a flatscreen today, they wait a year when they will be cheaper. The effect of falling prices is to depress consumer spending leading to lower economic growth. (why deflation is bad)
Question: Is that backed up by empirical evidence or is it something that economists repeat like religious dogma? This particular argument seems completely backwards to me, please could you help explain what is wrong with my observation of the flatscreen tv prices?
  • A rule of economics is that lower prices lead to higher demand for a particular good.
  • Yet, economists say that in a period of deflation - when general prices are falling, consumer tend to reduce spending.
How to reconcile the two?

Firstly, my quote could have been more careful. It would have been better to say this.

When general prices in the economy are falling, consumers tend to delay purchasing good and services. For example, rather than buy a flatscreen TV today, they wait a year when they will be cheaper.

Suppose we had an inflation rate of 0%, but flatscreen TV's were falling in price. Flatscreen TVs are becoming relatively cheaper. In this case, we would expect people to buy more flatscreen TVs.

However, suppose that we have deflation - a negative inflation rate. e.g. CPI = -2%. This means that the average price level is falling.

If the prices of goods are decreasing, empirical evidence suggests this is one factor that encourages people to delay buying because they think they will be cheaper in the future. The important thing is that all goods are decreasing in price.

Another way of thinking about it is, if you expected house prices to shoot up in the next two years, it may encourage you to buy now, rather than wait. If you expected house prices to fall, it would encourage you to delay buying.

Of course, not every consumer will delay purchasing, but even a small % who delay purchasing can cause a fall in aggregate demand or lower growth. Also combined with other factors such as a rise in the real value of debt it can lead to periods of negative economic growth.

The example of flatscreen TVs is perhaps not the best because the price of flatscreens has been very different to the average inflation rate. On average prices of goods and services have been rising 2%, but, flatscreens have been falling significantly.
  • From a micro perspective - lower prices of flatscreens relative to other goods, will encourage people to buy more.
  • From a macro perspective a negative inflation rate - a period of deflation, tends to depress consumer spending, as people often wait for buying expensive items.

However, there is no golden rule that deflation always has to lead to lower consumer spending and lower aggregate demand. I believe the US had periods of deflation in the nineteenth century and this was combined with strong economic expansion (though I would need to do some research)

Also, you indicate that if technological expansion is causing lower costs and lower prices this can lead to economic progress. If deflation is caused by improved productivity / better technology it can be compatible with higher growth.

But, if we look at the case of Japan, their deflation is generally agreed to have led to depressed consumer spending and depressed rates of economic growth. Prolonged deflation changed the attitude of consumers, consumers became much more frugal and unwilling to spend. People also dislike borrowing on credit, because in deflation, the real value of your debt will rise.

It was a similar situation in the 1920s and 1930s - the UK had deflation and this contributed to the low growth and mass unemployment of the era.

The EU, US look like they are heading towards deflation. But, I can't see this as being the 'positive deflation' it is more a result of spending cuts, lower consumer confidence and the credit crisis. Unfortunately, I can only see deflation in this circumstances as being damaging. Something that needs to be avoided.

Your observation about flatscreens is in one way correct, hopefully, this clears up why deflation can lead to depressed spending.

Further Reading



Mark Biernat said...

It is interesting to note that economists from the 1950s to 2010 were mostly concerned with inflation, however, in the 19th century the big problem was deflation.
Deflation seems good to many people, but you are right it is usually connected with lower investment and consumption.

Anonymous said...

Hi, just to add to your thoughts on deflation, is it that usually deflation occurs within the business cycle at a time when consumer confidence is low. That is to say that the economy has usually slowed and there are other factors at work that are also contributing to lower retail sales?