Accounting Conservatism

What is deflation?

Deflation is a general decline in the prices of goods and services, usually associated with a contraction in the supply of money and credit in the economy. During deflation, the purchasing power of money increases over time.

Key points to remember

  • Deflation is the general fall in the price level of goods and services.
  • Deflation is generally associated with a contraction in the supply of money and credit, but prices can also fall due to increased productivity and technological improvements.
  • Whether the economy, the price level and the money supply deflate or inflate, this changes the attractiveness of the different investment options.



Understanding deflation

Deflation drives down the nominal costs of capital, labor, goods and services, although their relative prices may remain unchanged. Deflation has been a popular concern of economists for decades. At first glance, deflation benefits consumers because they can buy more goods and services with the same nominal income over time.

However, not everyone wins from falling prices and economists are often concerned about the consequences of falling prices on various sectors of the economy, particularly in financial matters. In particular, deflation can harm borrowers, who may be required to pay their debts in money worth more than the money they borrowed, as well as financial market players who invest or speculate on the prospect of higher prices.

Causes of deflation

By definition, monetary deflation can only be caused by a decrease in the supply of money or financial instruments repayable in money. In modern times, the money supply is most influenced by central banks, such as the Federal Reserve. When the supply of money and credit decreases, without a corresponding decrease in economic output, the prices of all goods tend to fall. Deflationary periods most often occur after long periods of artificial monetary expansion. The beginning of the 1930s was the last time that significant deflation was recorded in the United States. The main contributor to this deflationary period was the decline in the money supply following catastrophic bank failures. Other countries, such as Japan in the 1990s, experienced deflation in modern times.

World renowned economist Milton Friedman argued that as part of an optimal policy, in which the central bank seeks a deflation rate equal to the real interest rate on government bonds, the nominal rate should be zero and the price level should drop steadily at the real interest rate. His theory gave birth to the Friedman rule, a rule of monetary policy.

However, the decline in prices can be caused by a number of other factors: a decline in aggregate demand (a decrease in total demand for goods and services) and increased productivity. A fall in aggregate demand generally results in a subsequent fall in prices. The causes of this change include reduced government spending, the failure of the stock markets, consumers’ desire to increase savings and tighter monetary policies (higher interest rates).

Falling prices can also occur naturally when the output of the economy grows faster than the supply of money and credit in circulation. This occurs especially when technology advances the productivity of an economy and is often concentrated in the goods and industries that benefit from technological improvements. Businesses operate more efficiently as technology advances. These operational improvements result in lower production costs and cost savings passed on to consumers in the form of lower prices. This is distinct but similar to general price deflation, which is a general fall in the price level and an increase in the purchasing power of money.

Price deflation by increasing productivity is different in specific sectors. For example, consider how increasing productivity affects the technology sector. In recent decades, technological improvements have resulted in significant reductions in the average cost per gigabyte of data. In 1980, the average cost of a gigabyte of data was $ 437,500; in 2020, the average cost was three hundred. This reduction also resulted in a significant drop in the prices of manufactured products that use this technology.

Changing views on the impact of deflation

After the Great Depression, when monetary deflation coincided with high unemployment and a rise in defaults, most economists thought that deflation was an adverse phenomenon. Subsequently, most central banks adjusted their monetary policy to promote steady increases in the money supply, even if this contributed to chronic price inflation and encouraged debtors to borrow too much.

British economist John Maynard Keynes warned against deflation because he believed it contributed to the downward cycle of economic pessimism during recessions when asset owners saw their prices fall, and therefore reduced their willingness to invest. Economist Irving Fisher has developed a comprehensive theory of economic depressions based on deflation of the debt. Fisher argued that winding up debts after a negative economic shock can lead to a further reduction in the supply of credit to the economy, which can lead to deflation which in turn puts even more pressure on debtors. , leading to even more liquidations and a spiraling spiral. the Depression.

In recent times, economists have increasingly challenged old interpretations of deflation, particularly after the 2004 study of economists Andrew Atkeson and Patrick Kehoe. After examining 17 countries over 180 years, Atkeson and Kehoe found 65 of 73 episodes of deflation without an economic slowdown, while 21 of 29 depressions had no deflation. Today there is a wide range of opinions on the usefulness of deflation and price deflation.

Deflation changes debt and equity financing

Deflation makes it less profitable for governments, businesses and consumers to use debt financing. Deflation, however, increases the economic power of savings-based equity financing.

From an investor’s perspective, companies that accumulate large amounts of cash or have relatively little debt are more attractive in the event of deflation. The opposite is true for highly indebted companies with little liquidity. Deflation also encourages higher yields and increases the necessary risk premium on securities.

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