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I.              Definition of Deflation 

In the WWII period, low inflation did not induce fears of deflation because economists believed the institutions created by the Keynesian revolution had a bias toward inflation. After more than 50 years of absence, deflation has now reappeared on the agenda as something to worry about. So what is deflation? Deflation is defined as persistent declines in the general price level.

II.             Different Types of Deflation and What It Is Not 

It is important to distinguish different types of deflation. Deflation can develop as a result of: 

·          Too restrictive monetary policy. The government can create a deflation if it runs a budget surplus and reduces the quantity of money.

·          Prices can also fall due to a surge in productivity, higher competition and more efficient use of resources. 

The latter is a good type of deflation as it increases the supply of goods and services, while the former is a bad type of deflation as it reduces the demand for goods and services. A common misconception about deflation is to mix up relative price change with deflation.  If some prices fall, e.g. computer prices due to technology advances or cheaper imports, this is not deflation but simply a relative price change as long as the general price is not persistently lowered.  Neither should deflation be confused with disinflation, which is a slowing down of the rate of price increases.

III.            Price Level Determination

The general price level is determined by aggregated demand and aggregated supply.  The price level increases when aggregated demand rises and/or aggregated supply decreases; conversely, when aggregated demand falls and/or aggregated supply rises, the price level decreases. Aggregated supply and aggregated demand are related to the monetary system.  When an individual has too much cash, he has an excess supply of money; the individual can reduce his excess cash by buying goods or securities. If individuals in aggregate have an excess supply of liquidity, it would correspond to an excess demand for goods and securities. This means that buyers have more money to spend than sellers have goods and securities to sell. The excess of offers to buy over offers to sell means that the price of goods and securities has to rise to clear the market. The higher price level reduces the value of money by reducing the real value of money balances. When individuals have too little cash, the process works in reverse as they try to sell more goods and securities hence driving down prices until the lower price level increases then the real money balances until the equilibrium level is reached.

IV.           Distributional Effects of Deflation

Deflation, like inflation, has distributional effects. Under deflation creditors gain while under inflation debtors gain. This is because borrowing arrangements are usually made in nominal terms. During unexpected inflation the creditor receives less than he expected, while during deflation he receives more in real terms. Deflation is especially destructive to debtors, who are committed to pay down their debt with more valuable cash out of incomes that shrink because of declines in the prices of the goods and services they produce. Therefore, it is asymmetrical in the sense that the loss of the debtor during deflation may not be able to meet his obligations which could lead to defaults while the creditor only receives less than expected during inflation.

V.            Asymmetries between Inflation and Deflation

There are also other important asymmetries between inflation and deflation. The most important difference is that during deflation the nominal interest rate is bounded below at zero, but during inflation there is no such upward bound. Furthermore, when money supply is increased, excess demand for goods will cause prices and wages to rise. However, prices and wages are not as flexible in a downward direction. Excess supply for goods therefore tends to cause a reduction in output and unemployment more than it tends to cause a fall in prices and wages. The reduction in output and the adjustment costs related to this leads to lower profits.   

The government can increase or decrease liquidity in the economy by adjusting monetary policy. However, there is an asymmetry in the process by which monetary policy works. If liquidity is sharply reduced, individuals and firms have to reduce their spending to remain solvent, whereas when the liquidity is increased, they can but do not have to increase their spending.  

VI.           Debt-deflation 

1.  Debt-deflation is defined as the fall in the price of assets. It usually follows sharp asset inflation and may or may not be accompanied by price level deflation. It is characterized by a sharp decline in asset values due to higher value of liquidity which leads to a fall in asset prices when people switch into cash. The fall in the value of assets reduces net worth, creates cash flow problems and makes it more difficult to carry out financial commitments. Debt-deflation will distress or even bankrupt financial intermediaries and may lead to systemic risk in the overall financial system. 

2.  Another type of debt-deflation arises out of large scale foreign-currency denominated borrowing by domestic entities in countries whose exchange rate suddenly depreciates sharply. The depreciation increases the domestic currency value of the foreign currency debt and impairs their balance sheets in the same fashion as conventional CPI deflation.

Many recent financial crises are of this nature, but it is unlikely to happen to the United States as the overwhelming debt is denominated in dollars.

VII.          Deflation’s Growth Impairment Channels

Different authors have emphasized different channels through which deflation reduces economic growth. Deflation could mean bankruptcy for leveraged operations. Reduced nominal value of collateral and reduced ability by debtors to service their loans could lead to deteriorating bank balance sheets and bank failures and reduction in the money supply. Corporate balance sheet deterioration would increase the spread between corporate and government papers. Depreciation increases hard currency debts in terms of local currency owed by domestic firms to foreign nationals. Reduction in net wealth and increased uncertainty leads to a desire for very liquid balance sheets; thus, reducing the demand for goods.

VIII.         Fear Factors

The main reason to fear deflation is that nominal interest rates cannot fall below zero; therefore, falling prices will lead to high real interest rates. Banks cannot pay negative interest rates to respond to anticipated deflation. Contracts are made in nominal term; thus, debt obligations increase in value in real terms when prices fall. Higher real rates, higher real wages and higher debt service costs lead to lower profits, plunging investments and lower demand and raising unemployment. Moreover, transfers of wealth from creditors to debtors inhibit the financial system, which further pressure the economy. Although we have a great weapon to fight deflation in monetary policy, it works with variable lags and is imprecise in its effect on price levels and interest rates.

Hans Nilsson

April 2002