In this article we will discuss about:- 1. Meaning of Deflation 2. Effects of Deflation 3. Control.
Meaning of Deflation:
The opposite of inflation is deflation. It is “a state in which the value of money is rising i.e. prices are falling.” It is usually associated with falling activity and employment. As pointed out by Coulborn, “Involuntary unemployment is the hall-mark of deflation.” Deflation is caused when prices are falling more than proportionately to the output of goods and services in the economy as a result of decrease in the money supply.
Sometimes, deflation is confused with disinflation. Deflation is a situation when prices fall along with reduction in output and employment. Disinflation, on the other hand, is a situation when prices are reduced deliberately but output and employment remain unaffected. According to Coulborn, “A lowering of prices, income, and expenditures, when they would be beneficial, would be disinflation.”
Effects of Deflation:
The effects of deflation are the reverse of inflation. Deflation affects different groups differently. Persons with fixed incomes such as workers, white collar salaried workers, pensioners, the rentier class, etc. gain because the value of money rises with falling prices. On the other hand, all types of producers such as industrialists and farmers lose with falling prices. Traders and equity holders also lose.
Thus deflation affects adversely the distribution of income and wealth. When prices are falling, the purchasing power is increasing. So the lower, middle, and other classes with low incomes gain. On the other hand, businessmen, industrialists, traders, real estate holders, and others with variable incomes are hit hard and their profits decline with deflation.
But this does not mean that there is improvement in income distribution. Rather, the low income groups suffer more because of the fall in employment and income. So both the better off and the worse off feel discontented under deflation.
Deflation also affects production adversely. With falling prices, production falls because income and employment are also declining and the aggregate demand is on the decline. Commodities start accumulating. Profits fall. Small firms close down. Unemployment spreads. This vicious circle of fall in demand, production, employment, income and aggregate demand leads to a depression.
The government also suffer under deflation. Revenues from direct and indirect taxes decline. The real burden of public debt increases. Development of the economy suffers because the government is unable to increase public expenditure.
Control of Deflation:
Deflation can be controlled by adopting monetary and fiscal measures in just the opposite manner to control inflation.
However, we discuss these measures in brief:
1. Monetary Policy:
To control deflation, the central bank can increase the reserves of commercial banks through a cheap money policy. They can do so by buying securities and reducing the interest rate. As a result, their ability to extend credit facilities to borrowers increases. But the experience of the Great Depression tells us that in a serious depression when there is pessimism among businessmen, the success of such a policy is practically nil.
In such a situation, banks are helpless in bringing about a revival. Since business activity is almost at a standstill, businessmen do not have any inclination to borrow to build up inventories even when the rate of interest is very low.
Rather, they want to reduce their inventories by repaying loans already drawn from the banks. Moreover, the question of borrowing for long-term capital needs does not arise during deflation when the business activity is already at a very low level.
The same is the case with consumers who faced with unemployment and reduced incomes do not like to purchase any durable goods through bank loans. Thus all that the banks can do is to make credit available but they cannot force businessmen and consumers to accept it.
In the 1930s, very low interest rates and the piling up of unused reserves with the banks did not have any significant impact on the depressed economies of the world. Thus the success of monetary policy in controlling deflation is severely limited.
2. Fiscal Policy:
Fiscal policy through increase in public expenditure and reduction in taxes tends to raise national income, employment, output, and prices. An increase in public expenditure during deflation increases the aggregate demand for goods and services and leads to a large increase in income via the multiplier process, while a reduction in taxes has the effect of raising disposable income thereby increasing consumption and investment expenditures of the people.
The government should increase its expenditure through deficit budgeting and reduction in taxes. The public expenditure includes expenditure on such public works as roads, canals, dams, parks, schools, hospitals and other buildings, etc. and on such relief measures as unemployment insurance, pensions, etc.
Expenditure on public works creates demand for the products of private construction industries and helps in reviving them while expenditure on relief measures stimulates the demand for consumer goods industries.
Reduction in such taxes as corporate profits tax, income tax, and excise taxes tends to leave more income for spending and investment. Borrowing by the government to finance budget deficits utilizes idle money lying with banks and financial institutions for investment purposes.
But the effectiveness of public expenditure primarily depends upon the public works programme, its importance in the economic system, the volume and nature of public works and their planning and timing.