Deflation refers to an increase
in the value of money. In layman's language, with the same amount of money you
would be able to purchase more goods. Let’s not confuse it with Disinflation,
which mean decrease in rate of inflation.
Is deflation good or bad for economy?
The good side of it is my money increases in real terms. Even if I don’t invest, my money can buy more goods
today than it would have bought yesterday. Let’s understand what is the bad side of it.
If there is deflation, consumers
would like to postpone their purchases because with less spending they would
get more goods the very next day. This will reduce the total consumption in
economy. If consumption decreases, industries would not be utilizing their
maximum efficiency. And therefore they will produce less and as a result will
have a hit on their bottom line (profit). If industries produce less, there
will be less demand of workers, and so the total money in hands of people will
also reduce. This will lead to a deflationary spiral, which will reduce the
overall economic activity and push the country towards recession.
The basic principal of finance
says that risk and returns are directly related. Like if you invest in most
secured ‘AAA’ rated US treasury, you would get the least interest rate. And if
you invest in ‘AA’ or ‘A’ or ‘B’ rated bonds, you have a chance to earn more
returns. In case of deflation an investor earns more returns with virtually no
risk at all. So he starts hording money and therefore reduces the liquidity in
the system.
Other big impact of deflation is
it affects the total borrowing of a country. Take for example, if I have
borrowed $100 from you and promise to return it after a month, with an interest
of 2% ($2). If my country is running Deflation of 2% a month, I would
effectively pay you $104. So the interest rate effectively increases to 4% (approx.).
How might have deflation came in the first place
Suppose there were 100 people
living in a country and there $1000 bills circulated. Suddenly the number of
people increases and equivalently if the amount of money does not increase,
than dollar will become dearer and its value will increases. Result is
Deflation
Another scenario is if the
overall efficiency of manufacturing plants increases, than the total goods
produced by them will increase. Also because of mass production the cost of
producing goods would decrease and therefore the amount of goods for the same
dollar will increase. This will again lead to Deflation.
Another reason for Deflation is
the new competition in an industry. Competitors enter into a sector which is
profitable and easy to enter. With competition, competitors would be forced to
sell cheap and this would result in purchase of more goods with the same amount
of money. Good for buyer but it will again lead to Deflation.
If the cost of goods decrease that does not mean the Price will also decrease. The economies of scale will not be achieved untill unless there has been investments, and they will need to have the same price in order to reap the benefit, otherwise they will not be able to generate return for the capital they have employed (either equity or debt).
ReplyDeleteThe other 2 examples also seem to be a little unclear, it would be great if you could throw some light on it.