Is Deflation Bad? The U.S. Experience

Is Deflation Bad? The U.S. Experience
Student Name
Institutional Affiliation
Date
Is Deflation Bad? The U.S. Experience
The Meaning of Deflation
Deflation is the general decline in the price of commodities. The major focus is the word “general.” Prices can decline in a particular sector due to an increase in productivity and a fall in costs. The demand for the output of the particular sector may be weak, relative to the demand for other goods and services. Since such price declines are sector-specific, and despite the discomfort they bring to producers in the affected sectors, they are not a challenge for the economy as a whole. As a result, sector-specific price declines do not constitute deflation. For deflation to occur, the price decline needs to be so widespread that broad-based indexes of prices like the consumer price index (CPI) register continuous declines. In the US, the CPI is the most commonly referenced index when evaluating inflation rates. When the index in one period is lower compared to the previous one, then it can be concluded that general prices have reduced, demonstrating that the economy is experiencing deflation. Deflation may be a result of a combination of the supply and demand for products together with the demand for money. This is especially where the supply of money reduces while that of goods goes up. Historically, when deflation has occurred, increased productivity has led to an increase in the supply of goods without the supply of money increasing. This is the case with the Great Depression from 1929-1939. And possibly in Japan in the early 1990s.
An understanding of deflation requires an in-depth examination of its causes both on the demand side. On the demand side, deflation occurs where there is growth deflation and hoarding. Growth deflation implies the enduring decrease in the real cost of goods and services due to technological progress, which is followed by aggressive price cuts, leading to an increase in aggregate demand. An oversupply of the markets results in drastic price cuts. Regarding hoarding, when people expect prices of goods and services to continue reducing, they are likely to hoard their money, waiting for a further decline. Investors and buyers hoard money since its value is increasing over time, in the hope of purchasing more products in the future. On the supply side, deflation occurs due to bank credit deflation, debt deflation, decisions on the money supply side, and credit deflation. Bank credit deflation occurs when a decrease in the bank credit supply occurs because of the failures of the bank or when banks consider private entities to be high risk. It can also occur when the central bank contracts the supply of money. Money supply-side deflation demonstrates deflation to be major because of a reduction in the velocity of money. Credit deflation occurs when the central bank initiates higher interest rates, as one of the measures of controlling inflation. In the modern day where economies are credit-based, a decline in lending means less money in circulation, which is accompanied by a sharp fall-off in demand for products. Banks intervene to halt the deflationary spiral by withhol...