Why is Deflation So Bad For the Economy?

Why is Deflation So Bad For the Economy?

Economics Help OnlineDeflation is the negative change in prices. Today, developed countries are even taking extraordinary measures such undergoing quantitative measures to combat deflation.  The economic statistics of the changes in consumer prices in most countries are often compiled by drawing comparisons between changes of diverse products to an index. Consumers usually think that a general decrease in the prices of goods is a good thing since it gives them greater purchasing power. However, a persistent decrease in prices can have a disastrous effect on economic stability and growth.

Recessions and Deflation

Economic crisis periods often lead to deflation. This is because economic output reduces as demand for investment and consumption slows when an economy undergoes extreme depression or recession. As a result, an overall decline in the prices of assets occurs and producers are forced to liquidate inventories that consumers are not interested in buying. Holding onto liquid money is deemed by both consumers and investors as a way of cushioning against further financial loss. The aggregate demand further decreases as more money are saved and less is spent.

The Vicious Cycle of Deflation

Companies are forced to reduce their workforce to accommodate a decrease in demand as production slows. This usually leads to an increase in unemployment since these retrenched individuals find it hard to get another job during a recession. In the long run, after depleting their savings in trying to make ends meet, the unemployed are forced to default on various debt obligations such as credit cards, mortgages and car loans among others.

The financial sectors are forced to write off the defaulted debts as bad losses. This leads to banks’ balance sheets becoming shakier as clients seek to withdraw their cash before the bank fails. If too many deposits are redeemed, a bank run may ensue. Since the financial institutions are collapsing, the much-needed liquidity is removed from the system. This also leads to a reduction in the supply of credit to individuals and firms seeking new loans.

To combat this, central banks undertake measures such as pumping money into the economy through open market operations and lowering the interest rate target. If these fail to spur economic growth, central banks may resort to undertake quantitative easing. In addition, if the financial sector has been severely hit by such events, the central bank can also step in as the lender of last resort.

The Bottom Line

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