Deflation – Indian Economy Notes

The term "deflation" refers to a general fall in the prices of commodities. Although it may appear to be beneficial, it is not good for the economy. Deflation is commonly linked to economic slowdowns, poor productivity, and job losses. Inflation lowers the value of money, while deflation raises it. This encourages consumers to save money now in order to buy products later when they are cheaper. And as a result of this economic behaviour, growth slows down even more.

Deflation as a topic holds great importance in the Economy syllabus of the UPSC IAS Exam.

What is deflation?

• We will have a general price level at full employment when aggregate supply will match aggregate demand. Deflation is the reduction in this general price level.
• An increase in this general level of price is called Inflation.
• For Example, if a product that cost Rs.200 last year is costing Rs.150 now. Then it is said to have undergone deflation.
• The nominal costs of capital, labour, goods, and services fall as a result of deflation, even if their relative prices remain unchanged.
• Consumers benefit from deflation on the surface because they can buy more goods and services over time with the same nominal income.
• Lower prices, on the other hand, do not benefit everyone, and economists are frequently concerned about the effects of falling prices on various sectors of the economy, particularly in financial matters.
• Deflation can be particularly harmful to borrowers, who may be forced to repay their debts in money that is worth more than the money they borrowed, as well as financial market participants who invest or speculate on the prospect of rising prices.
• Deflationary Gap: It is the difference between the general level of prices and the fall in the level of prices due to deflation.

Causes of Deflation

Deflation can be caused by multiple factors:

• Changes in capital markets structure: When companies providing identical goods or services compete, they seek to cut prices in order to gain a competitive advantage.
• Higher propensity to save: People start saving instead of spending in the hope of a future fall in prices. This reduces the demand and the prices further drop.
• Productivity gains: Innovation and technology allow for greater manufacturing efficiency, resulting in cheaper prices for goods and services.
• Reduced currency supply: As the quantity of currency decreases, so will the prices of products and services, making them more affordable to individuals.

Effects of Deflation

Deflation in an economy means that things are becoming worse. Following are its effects:

• Low Growth: Deflation is usually associated with high unemployment and low levels of production of products and services.
• Reduced Revenues in the Business: To stay successful in a deflationary economy, firms dramatically lower the pricing of their products or services. Revenues begin to decline as prices are reduced.
• Reduced Wages and Layoffs: As sales decline, firms find ways to cut costs in order to reach their goals. One method is to reduce wages and layoffs. This has a negative impact on the economy since consumers will have less money to spend.
• Reduces consumer spending: When prices are falling, people are more likely to postpone purchases in the future because they will be cheaper.
• Increase the real value of debt: Deflation increases the real value of money and debt. Debtors find it more difficult to repay their debts as a result of deflation. As a result, consumers and businesses must devote a greater portion of their disposable income to debt repayment. (In a deflationary period, firms will receive lower revenue, and consumers will likely receive lower wages.) Negative inflation would make it difficult for Indian corporations to repay debts as their debt burden would rise.
• Real wage unemployment: 'Sticky wages' are common in labour markets. Workers, in particular, are resistant to nominal wage cuts (no one likes to see their wages reduced, especially when they are accustomed to annual raises). As a result, real wages rise during deflationary periods. This could result in real-wage joblessness.
• No incentive to produce: producers, whether in manufacturing or farming, require inflation to increase their profits. If prices fall, producers will cut back on production, resulting in a supply shortage in the long run.
• However, there is also one Positive Effect of Deflation:
  • Greater Export Competitiveness: If most other economies are suffering inflation, a positive effect of deflation could be increased export competitiveness. Exports will be profitable as the rate of products and services falls.

Deflationary Spiral

• Fall in prices leads to lower profit to businesses, which in turn leads to lower production. The workers are given lower wages or are laid off.
• This gives rise to lower demand in the economy as people have no money to spend and the prices fall further.
• This cycle keeps repeating itself and is called the Deflationary Spiral.

Difference between Disinflation and Deflation

Often confused, disinflation is not the same as deflation.

Measures to address Deflation

• Government should follow a Cheap/Easy/Dovish Monetary Policy to make loans cheaper.
• Individuals should be provided with tax deduction/subsidy types of benefits to encourage the purchase and expenditure.
• Government should increase the expenditure on public projects eg. highways, dams etc. to boost demand in the steel/cement industry. This will also get people employed and their purchasing power will increase, this will increase the demand and the general price levels can be then attained.

FAQs

MCQs

Question: What is the best description of Deflation?

(a) Sudden fall in the value of rupee against other currencies

(b) Fall in the rate of inflation

(c) Persistent Recession in the economy

(d) Persistent fall in the general price level of goods and services

Question: A fall in the general level of prices may be caused by:

(a) An increase in the money supply

(b) An increase in effective demand

(c) An increase in the propensity to save

(d) An increase in the propensity to consume