Macro Moves

What is Deflation? Why are falling prices bad for your pockets?

Created on 03 Aug 2022

Wraps up in 5 Min

Read by 775 people

Updated on 11 Sep 2022

Have you noticed you end up spending more money during the sale season? Some retail therapy never hurt anybody, especially when it comes to good deals and low prices. But what if these prices went down consistently? Your instincts and wallet may think it’s a good thing, but economists believe differently. The rising and falling prices have always been one of the most significant indicators of our economy’s performance. We all know and have experienced how rising prices can hurt an economy. But a little inflation is a good thing. Economists would any day prefer a gradual rise over the constant drop in prices. Let us understand why! 

Understanding Deflation

Deflation is the consistent and general decline in the economy's overall prices of goods and services. As prices deflate, the purchasing power increases and people can consume more with the same nominal income. It might sound like a blessing initially; after all, who doesn't like cheaper stuff, but in the long run, it is pretty detrimental! 

Let’s take an example where you wish to buy a phone. You notice that the price decreases from Rs 20,000 to Rs 19,000. This temporary fall in price may encourage you to purchase the product today. However, you might wait until tomorrow for the prices to drop further. This anticipation may discourage you from spending money today. Many individuals think along the same lines, and this delayed spending is observed at a larger scale in an economy. This causes the overall prices to fall, resulting in decreased consumer demand, low profits, low wages, low employment, low income, low spending and lower prices, thereby creating a vicious circle or a deflation spiral.   

Thus, prolonged deflation has adverse effects on all financial aspects and indicators in the country and must be curtailed in time. But how do we do this? We need to dig deeper. 

Cause of Deflation

Deflation might be a rare occurrence but is troublesome and something to look out for. Economists have traced the root causes of deflation to a decrease in aggregate demand and an increase in aggregate supply. However, multiple sub-factors trigger these two primary factors and are discussed below. 

1. Decrease in Aggregate Demand: This simply means a change in consumers' buying behaviour where they do not wish to spend a lot and therefore demand fewer products, decreasing the overall economic demand. Following are the economic factors that lead to a decrease in aggregate demand:

  • Decrease in money supply- This refers to less money circulating in the economy. When the central bank increases the interest rates, borrowing cost increases and the capacity to spend more by taking loans decreases. The flow of money between sectors reduces. 

  • Decline in confidence- During low phases of the economy, such as recession, people may develop a pessimistic outlook and become more cautious of their future by saving more and reducing their spending.

2. Increase in Aggregate Supply: Rapid growth in the production of goods and services can reduce prices due to fierce competition and subsequent deflation. 

  • Low production costs- A decline in prices of key production inputs can significantly cut production expenses, and more goods can now be produced at the same cost. This could lead to an oversupply of such goods or services in the economy. If the demand remains unaffected, producers will continue to reduce prices and increase the supply of goods. 

  • Increase in productivity- By developing innovative techniques or improvised methods, producers may reduce the cost of goods and increase supply.

  • Technology advancement- Rapid advancement of technology or cost-cutting tools leads to an increase in the aggregate supply by simplifying the production process and reducing the time and cost of the same. 

  • Change in Capital Market Structure- Often, the capital structure changes due to varying reasons such as lower interest rates, changing banking policies, etc. which could make raising capital more accessible. Businesses may use this new capital to increase productivity which would increase supply. 

Effects of Deflation on the Economy

So far, we understood that deflation has detrimental effects on the country’s economy and must not be mistakenly dismissed as a pocket-friendly phase. Now let us take a closer look at what these effects are. 

1. Fall in Demand-  As we have discussed before, temporary deflation increases demand as prices of goods and services decrease temporarily. However, the same phenomenon over time can lead to reduced demands as consumers begin to save more or delay spending, speculating further price reduction. There is an imbalance of demand and supply affecting the overall economic consumption. 

2. Reduced Profits-  As there is an oversupply in the economy, producers offer goods and services at lower and lower prices to sell out stocks. Therefore, the profits available to producers decrease. 

3. Rise in Unemployment-  With decreasing demand and profit margins, businesses no longer require the same number of workers as they aren't selling as much. They either lower the worker’s wages or, worse, lay them off. At large, this creates the issue of unemployment. 

4.Fall in Credit-  In a time of need, people usually turn their heads toward lenders for financial aid. But what if the lenders pull the plugs on such a facility? As deflation rears its head, financial lenders do not find it feasible to provide credit as prices of most collateral reduce along with people’s repaying capacity due to lower wages. Less and less people remain eligible for attaining loans. This further negatively affects the outflow of money from households into the economy. 

5. Reduction in Investments-  With low disposable income and no credit facility, businesses and consumers have to manage with their limited funds and therefore save more and avoid investments. 

6. Increased Debt burden-  Since there are no new investments, there is no new source of income while the existing pool of funds keeps depleting. Existing debts take longer to repay, adding the interest amount and increasing the debt burden. 

7. Strengthening currency-  On a slightly positive note, international firms can purchase more for lesser amounts as deflation pushes down prices. This encourages them to do more business with our country. The demand for our currency increases as exports increase; incidentally, its value also increases. 

These effects trigger a chain reaction that, if not tended to in time, can create the deflation spiral, which is nothing short of a quicksand and must be avoided at any cost.

The Bottom Line

Not all that shines is gold, and deflation taught us just that! With its deceptive low prices, we got sucked into the idea that deflation could be a good thing. But deflation, as the name suggests, is like air getting sucked out of the economy. However, it’s harmful only when the prices fall consistently. So the next time you see a discounted product, don’t worry about the country’s financial performance; you deserve to enjoy those!

An Article By -

Yashi Ojha

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Yashi is currently pursuing Chartered Global Management Accounting. Her creative, artsy heart but number-crunching mind has led her to financial content writing. She would prefer to be the observer & the listener in the room so she can soak in all the knowledge from the rest, but wouldn’t compromise on being the funniest.

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