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Deflation: Causes, Effects & U.S. CPI Index

7 pages
1769 words
Sewanee University of the South
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Deflation takes place whenever the prices changes turn to be negative. In regards to the causes and effects of deflation, it is worth to note that changes in the consumer prices remain economic statistics compiled in various countries via the comparison of the variations of the basket of goods and products to a given index. It is worth to note that in U.S. CPI (Consumer Price Index) stand to be the most main referenced index paramount for the evaluation of inflation rates. Whenever changes in prices in a given period appears to be lower compared with the previous period, CPI index decline thereby showing that the economy is going through deflation. The reality of the matter is that some can consider the general decrease in prices as a good thing since it enables consumers to have a higher purchasing power. To some extent, moderate drops in given products including food or energy may have a positive effect on the spending of the consumer. All in all, the general persistent price falls can nevertheless result in severe adverse effects on the stability of the economy and growth (Ryska 145).

Under normal circumstances, deflation occurs in and after the economic crisis period. This can be explained following the fact that when a given economy experiences severe depression or recession, the result is that economic output goes slow while investment and demand for the consumption drop. This, therefore, results in a decline of the overall asset prices even as producers become obligated to liquidate inventories that are no longer needed to be bought by people. Similarly, investors and consumers start holding into liquid money reserves as a way of cushioning against the increase in the loss of finances. Thus, when a lot of the money gat saved, little money is left for spending, in that way decreasing aggregate demand. It is at such point that the expectations of the people regarding future become lowered thereby commencing to hoard money. Logically it becomes easy for the people to reason that there is no need of spending a dollar today when there is an expectation that it could be valued more tomorrow thereby buying more stuff. Similarly under the same reasoning why should on contribute tomorrow when expecting that next week things may be cheaper and so on (Kaufmann 2).

Deflation's Vicious Cycle undertakes that following the slowdown of the economy in accommodating lower demand, the fact is that companies reduce their workforce in that way reducing employment. The increased unemployed people in most cases end up having a hard time finding new work at the time when there is a recession; hence most likely depleting their savings to make ends meet. Ultimately they default their debts obligations including mortgages, students loans, car loans as well as credit cards. Such accumulated bad debts flow via the economy to the financial sectors that they have to write them off as losses. When the balance sheet, of the bank, becomes shakier, depositors are forced to withdraw their cash in case the bank falls. It is imperative to note that the bank run may arise upon which many depositors appear to be redeemed to a point where the bank can no more be in the position of meeting its obligations. Following is the collapse of the financial institutions hence eradicating the much-required liquidity from the system besides reduction of the supply of credit to those in need of new loans. Often the central banks respond via enactment of the expansionary monetary policy that includes lowering of the rates of interests target, as well as, pumping money into the economy via operations of the open market in this case buying treasury securities in a free market in exchange of the newly created money. Such measures are unable to stimulate demand thereby spurring the growth of the economy; central banks have the choice of undertaking quantitative easing thereby acquiring riskier private assets in the open market. Moreover, the central bank also may engage as the lender of last resort in case the financial sector remains severely hindered by various events as mentioned above. Government as well employs expansionary fiscal policy via lowering of the taxations besides increasing government spending. From this perspectives the problem of having taxes reduced in a moment of low prices together with high rates of unemployment entails the fact that the overall revenues from taxes will be reduced, thereby limiting the full operational capacity of the government (Blyth 115).

Ryska (113) notes that in all aspects it is right to argue that a little bit of the inflation is healthy for the growth of the economy approximately 2 to 3 percent per annum. However, in the situation whereby prices commence falling following the downturn of the economy, there is a high likelihood that deflation may set in thereby being the cause of the more severe and more profound crisis. Considering all these it is right to undertake that deflationary period remains a dangerous period for the economy of any given country. A fall in the consumer expenditure subsequently not only weakens the general activities of the economy but as well puts pressure on the prices which thereof causes spiraling economic activity decline. From such thinking, it can be concluded that the general fall in prices ought to be connected to the economic slump. The question we need to ask ourselves is whether fall in prices is at all times bad news for the economy. For example in a situation where general fall in prices emanates from the expanded manufacturing of goods and services, can it be considered as bad news?

In case deflation leads to economic slump; therefore, following the popular thinking logic, it would be true that policies reversing deflation ought to be good for the economy. They are considering that deflation indicates the introduction of the systems that boost the general increase in prices of goods-inflation meaning that inflation ought to be the economic growth agent. According to various scholars, a little bit of inflation can be a good thing. Thus they look forward to the Fed to produce an inflation "buffer" to hinder the economy from falling into the black hole of deflationary. Such experts hold that the rate of inflation of about 3 percent might be the suitable protective "buffer." Moreover mainstream thinkers think that inflation of 3 percent cannot be harmful to the growth of the economy; however, inflation of 10 percent is bad news. From this thinking perspective, an inflation rate of 3 percent means that consumers will not have their spending postpones on various goods thus will no set in motion of the economic slump. However inflation at the rate of 10 percent it is most probably that consumers form rising inflation expectations. In regards to the popular thinking responding to the high rate of inflation, consumers are expected to speed their expenditure on the available goods which ought to boost the growth of the economy. But the question one might ask is why then when the inflation rate exceeds 10 percent becomes a bad thing? This remains one of the problematic thinking in the world of economics (Hay 461).

It is equally imperative to note that general fall in prices can as well as be a result of a fall in the money stock. A critical cause of such fall ought to be the decline of the fractional reserve lending. It is worth noting that the presence of the central banking together with fractional-reserve allows commercial banks to produce credit note supported by the real savings which represent credit created out of thin air. The moment unbacked credit is produced it generates activities that cannot be supported by the free market consuming but not producing real wealth. The reality is that as long as there is expanding of the pool of real savings while at the same time banks are eager to have the credit extended, then many false activities prosper. When the extension of the creating credit out of thin air lifts the pace of consuming real-wealth beyond the speed of producing real wealth the pool of real saving is undermined. As a result, the performance of the different activities starts deteriorating while the bank's bad loan commences rising. Responding to this, banks tend to have their loans curtailed thereby not renewing maturing loans hence setting in motion of decline in the money stock. It is from this perspective that is worth noting that the decrease in the money stocks pave the way for deflation (D'Acunto and et al. 15).

In summary, the truth is that deflation is good and heals the economy. From the above discussion, it is apparent that deflation emanates in response to previous inflation. Therefore it is worth noting that as a general rule increases in prices labeled as inflation demands for improvements in the money supply. Thus a fall in the money supply results in a fall in general prices branded as deflation. This represents the disappearance of the money that was produced initially out of thin air. Such category of money generates various nonproductive activities by way of sidetracking real savings from the operations that create real wealth. A fall in the money stock reduces unproductive activities, slow down the decline of the pool of real saving thereby laying a foundation of the economic revival. The emergence of the deflation begins the process of economic healing thereby arresting destitution inflected by previous monetary inflation. Deflation strengthens wealth producers in that way revitalizing the economy. The wrong side of deflation is caused by the earlier inflation, and all that is done by deflation entail shattering the illusion of prosperity produced by monetary pumping. An economy is said to experience bad deflation whenever people become uncertain concerning the future, tends to be afraid of losing their jobs, and when government becomes over-indebted thereby making people fear higher taxes. The bottom line is that deflation is just a symptom and should not be feared. It is essential that investors, consumers be considerately positive thereby refusing to give way to a pessimistic observation.

Works Cited

Blyth, Mark. "Will the politics or economics of deflation prove more harmful?." Intereconomics 50.2 (2015): 115-116.

D'Acunto, Francesco, Daniel Hoang, and Michael Weber. "Inflation expectations and consumption expenditure." Chicago Booth Global Market Working Paper Series (2015).

Hay, Colin. "Good inflation, bad inflation: The housing boom, economic growth and the disaggregation of inflationary preferences in the UK and Ireland." The British journal of politics and international relations 11.3 (2009): 461-478.

Kaufmann, Daniel. Is deflation costly after all? Evidence from noisy historical data. No. 421. KOF Working Papers, 2016.

Ryska, Pavel. "DEFLATION AND ECONOMIC GROWTH: THE GREAT DEPRESSION AS THE GREAT OUTLIER." Quarterly Journal of Austrian Economics 20.2 (2017): 113-145.

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