Increasing attention is now being placed on deflationary pressures in modern economies. What causes deflation and why are economists and policy-makers concerned about it?

What is deflation?

Deflation is defined as a period when the general price level falls. It is normally associated with falling level of AD leading to a negative output gap where actual GDP < potential GDP. But deflation can also be caused by an increase in a nation’s productive potential which leads to an excess of aggregate supply over demand. We will look at perhaps the most prominent example of a country that has suffered deflation – Japan’s deflationary spiral – a little later in this note.

Possible Economic Costs of Deflation

1. Holding back on spending: Consumers may opt to postpone consumption if they expect prices to fall further in the future
2. Debts increase: The real value of household, corporate and government debt rises when the price level is falling – another factor that might cause people to cut back on their spending
3. The real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line with prices – another factor driving spending lower
4. Lower profit margins: Company profit margins come under pressure unless costs fall further than final prices to consumers – this can lead to higher unemployment as firms seek to reduce their costs. Weaker profit margins can also have a negative effect on stock markets because of a fall in expected profits and dividends to shareholders
5. Confidence and saving: Falling asset prices such as price deflation in the housing market hit personal sector financial wealth and confidence – leading to further declines in AD and a rise in precautionary savings (the average and marginal propensity to save will tend to rise)

Difference between Benign and Malign Deflation

Deflation is not necessarily bad! If falling prices are caused by higher productivity, as happened in the late 19th century, then it can go hand in hand with robust growth. On the other hand, if deflation reflects a slump in demand and excess capacity, it can be dangerous, as it was in the 1930s, triggering a downward spiral of demand and prices. If the falling prices are simply the result of improving technology or better managerial practices, that is fine. Consider what has happened to the costs of transport and telecommunications over the years.

Today we have something of that benign deflation. When you make a telephone call to the United States for 3p a minute or fly on a low cost airline to European destinations for less than £30, the consumer is getting the benefit of technology and increased competition in the form of lower prices leading to an improvement in economic welfare!

Malign Deflation

Malign deflation occurs when prices fall because of a structural lack of demand which creates huge excess capacity in an economic system. If there is a slump in demand, companies go out of business and sack people, and hence demand falls again – the negative multiplier effect starts to have its effect.

The Situation in the UK

Although there has been genuine deflation in several industries within the UK over the last few years, notably in textiles and clothing, audio-visual equipment and airline transport, the economy as a whole has experienced low but positive inflation as measured by the consumer price index. The risks of deflation are mitigated by the symmetrical inflation target given to the Bank of England – recognition that deflation can be as costly and dangerous to the health of the British economy as a sharp acceleration in inflation. The Bank of England stands ready to boost aggregate demand through interest rate cuts if there is a serious threat of inflation under-shooting the target. Another factor to consider is that inflationary expectations in Britain remain positive at or around 2.5% per year – people do not yet consider outright deflation to be a probably outcome for the economy.

Low and stable inflation which does not affect the day to day decisions of businesses and consumers is known as price stability.

 

Can economic policy reduce the risk of deflation?

Monetary Policy

Cuts in interest rates can be made to stimulate the demand for money and thereby boos consumption. But this is not always an effective strategy for reducing the risks of deflation:

1. If consumer confidence is low, the impact of a monetary stimulus might be small as people are more likely to save any increment to their income perhaps to enable them to pay off some of their accumulated debt
2. If asset prices are falling, the demand for cash savings will remain high – therefore consumption may not respond to lower interest rates
3. There are limits to how far monetary policy can go in boosting demand because nominal interest rates cannot fall below zero

When cuts in interest rates have little or no impact on demand, then the economy is said to be experiencing a liquidity trap. When interest rates are close to zero, people may expect little or no real rate of return on their financial investments, they may choose instead simply to hoard cash rather than investing it. If monetary policy is therefore ineffective in stimulating demand, the solution may be to use fiscal policy as a means of kick-starting demand and output.

One possible solution is to seek to “monetise the economy” by large scale buy-backs of government debt by the central bank to inject cash or liquidity into the economy. This was an option considered by the Japanese government during their deflationary recession in the late 1990s.

Fiscal Policy

A fiscal expansion of AD can come directly through higher government spending and/or an increase in public sector borrowing. Secondly the threat of deflation might be reduced through lower direct taxes to boost household disposable incomes. Both of these strategies seek to boost incomes and inject extra spending power into the circular flow of income and spending. The tax cuts might be announced as temporary to deal with a specific deflationary threat. But again there may be some limits to the effectiveness of fiscal policy in these circumstances:

1. There are consequences for national debt and the interest payments on this debt if the fiscal expansion package is too large. The government might end up providing a short term boost to demand, but have to cope with a significant increase in debt repayments in future years
2. Low consumer and business confidence might again reduce the impact of any fiscal stimulus
3. Lower taxes and higher public spending might stoke up some inflationary pressure if too much stimulus is applied for too long (once the economy starts to recover)
4. If tax cuts or public-works programmes are seen as temporary, while confidence is low, then extra incomes tend to be used to re-paying debt or restoring savings. Households may see this as their priority, rather than fuelling increases in consumption

 

The risks of deflation for the UK are fairly small. We must be careful to make a distinction between disinflation in industries due to technological change, excess supply, regulatory intervention or productivity improvements – such as in telecommunications, motor vehicles and audio-visual equipment, and deflation across the whole economy which in theory poses much greater risks. Providing that economic policy-makers are alert to the possible causes of genuine deflation, and respond at the right time when those risks are clear, then they should have enough flexibility in their monetary and fiscal policy armouries to counter the threat posed by deflation.

Suggestions for further reading and research
Consumers enjoy falling prices (Evan Davis, BBC)
Japan price rise means end to deflation (BBC) see also “Japan scraps zero interest rates”