An Expanded Overview on the Effects of Deflation An initial response might well be, Oh Goody, now I can buy things cheaper and I can save more, without inflation undermining my saved dollars And that is true, but, knowing prices are dropping, perhaps you will delay your larger purchases as well, thinking prices will be lower next month and save even more now. Now what if everyone started doing that? That is a whole lot of lower current consumption spending in the economy and that means aggregate demand will fall, slowing growth or perhaps even shrinking the economy. Remember todays government and consumer spending and volume of exports are tomorrows income. Reduce any or all of those spending categories and growth in the economy slows or, if there is no growth, the the economy just shrinks into recession or worse, a depression, depending on how vicious the deflationary spiral becomes. The situation can truly become nasty. Your Oh, Goody might also change, as you think about the impact of falling prices on your mortgage and credit card debt. You now have to pay those debts back with dollars that buy more, which is to say you have to give up more purchasing power to make your debt payments, which hurts you but helps your creditors, assuming you dont default. So falling prices hurt debtors and might help creditors, as well. Presently, we know commodity prices are falling especially oil which is used to manufacture a lot of things. Other commodities -- metals, lumber, etc. -- are also used in manufacturing and their prices are falling too. That means manufacturing costs are dropping so manufacturers and retailers can drop their prices too while still maintaining their margins, causing prices to fall further. But as prices fall, so does consumer demand for goods and services, as explained, Manufacturers and retailers like higher, not lower prices prices. Lower prices tend to squeeze their margins because of lower sales from reduced aggregate demand. Also, greater uncertainty attends the situation, and people curb their business and entrepreneurial activities in the face of rising uncertainty. This slows or shrinks the economy further. As the economy slows or shrinks, manufacturers and retailers then tend to lay off employees mostly and/or sometimes reduce their wages. This further shrinks the economy and reduces aggregate demand further. This also reduces the demand for raw materials or commodities to manufacture goods and cause their prices to drop even further, exacerbating the problem. Creditor defaults and bankruptcies rise further injuring consumers. A vicious accelerating circle attends, with a growing downward spiral. This is the major downside of the ups and downs that are capitalisms Achilles heel. Economic growth is greatest with slight inflation in the range of 1 to 2 percent. Economic contraction is greater, the greater the rate of deflation. Economic collapse is the end game of deflation. We are clearly headed toward deflation just now (Republican predictions of inflation notwithstanding). How serious it will become remains to be seen.
Posted on: Fri, 19 Dec 2014 22:09:13 +0000
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