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What is Deflation and what are its effects on the economy?

Most people are familiar with the phenomenon of inflation as a fact in their lives. But in some economic conditions, the exact opposite phenomenon occurs, called “deflation”. After reading this article, you will get acquainted with the concept of negative inflation, the effects of this phenomenon on society and its solutions.

What is Negative Inflation?

Negative inflation means a gradual decrease in the price of goods and commodities, and an increase in the value of the national currency against the goods and commodities in a country. When the inflation rate falls below zero, the price of goods gradually decreases and a person can buy more goods with the money he has. According to this definition, at first glance, negative inflation may seem good, but the consequences of this phenomenon show the opposite.

Negative inflation can hurt the economy as much as high inflation. This phenomenon can increase the unemployment rate by significantly reducing wages and stagnating production. This phenomenon gradually reduces the profitability of businesses and makes it difficult to develop and create new businesses. In times when a country’s inflation is negative, people are reluctant to spend their money and the desire for productive investment is drastically reduced.

Negative inflation should not be equated with declining inflation. In reducing inflation, the inflation rate is still above zero but decreases. While when inflation is negative, the inflation rate falls below zero.

What causes negative inflation?

What is Deflation and what are its effects on the economy?
Supply and Demand

There are several factors that can cause negative inflation, but the root of all of them is a wide change in the supply and demand curve. Remember that the price of all goods and services is related to supply and demand, and this means that if the supply of a good or service is constant, if the demand decreases, the price decreases accordingly. Changes in the supply and demand of a national currency also play a key role in determining the value of a country’s goods and services.

Although many reasons can be given for negative inflation, the following play a major role in this phenomenon:

Sudden changes in the structure of capital markets

When a large number of different companies all sell the same product or service, they will have to gradually reduce prices to compete with each other. Often, the capital structure of an economy changes and companies gain easier access to credit. Borrowing companies with the capital raised can improve their business or their production.

Companies can increase their capital by lowering interest rates, changing banking policies or increasing investors’ willingness to take risks. After improving their business, increasing production, and ensuring a flow of profits, these companies can lower the price of their goods and services to outperform their competitors, which can cause or at least contribute to negative inflation.

Increase production rate without demand

Innovative solutions and the development of new technologies will help increase efficiency, which will ultimately lead to lower prices. While some innovations only affect the products of certain industries, others have a profound effect on the economy as a whole.

For example, after the collapse of the Soviet Union in 1991, most of the newly independent states faced many problems. Many citizens of these countries were forced to work for very low wages in order to survive, and because American factories operated in these countries, they were able to greatly reduce their costs and boost production by employing native workers. کردن. This inevitably increased supply and reduced costs, resulting in a period of negative inflation in the United States in the late twentieth century.

Decrease in money supply

As the supply of money to the market decreases, money becomes more valuable, prices fall, and people can buy more goods with their own money. But how does the money supply decrease? You should find the main reason in the central banks.

For example, the US Federal Reserve, in its first year of operation, largely controlled the US monetary reserves, which was one of the causes of negative inflation in 1913. In many economies, credit is often funded. Because of this, when credit bureaus refuse to lend, consumers will spend less, forcing sellers to lower prices to maintain sales.

Austerity measures

Negative inflation can be caused by reduced spending by government, businesses or consumers. When the government cuts spending by cutting welfare and aid schemes, it can lead to negative inflation if the spending cuts are large. For example, when Spain began austerity in the early 2010s, its inflation rate fell to negative 1.37.

Negative effects of inflation

What is Deflation and what are its effects on the economy?

Periods of negative inflation are also called “economic winters”. In some economies, the effects of negative inflation are felt for years on the structure of financial markets. Hong Kong, for example, which suffered from terrible negative inflation in 2002, has not been able to recover for ten years.

Negative inflation can do the following damage to an economy:

Decreasing the income of businesses

In times when inflation is below zero, businesses are forced to lower the prices of their products to stay competitive. Obviously, as product prices fall, so do revenues. Decreasing its income is accompanied by downsizing, declining production, and the like.

Reducing wages and downsizing

When revenues fall, companies will seek to cut costs to exit the crisis. One of the main ways to reduce costs for companies is to reduce staff or reduce wages.

Drastic changes in consumer spending

The relationship between negative inflation and consumer spending is complex and difficult to predict. When the economy enters a period of negative inflation and prices fall, we may initially see a sharp increase in consumer spending, but after a while with declining output, rising unemployment and a reluctance to invest, as well as an increase in the value of the national currency, We see that people are spending less money to save in future crises.

Decreased willingness to invest

In times of negative inflation, cash is the best investment; Unlike periods of inflation where cash should not be kept. At the time of this phenomenon, people’s desire to invest in productive assets will decrease, and the government will have a hard time convincing people to spend their money. In periods of negative inflation, stock markets fall.

Reduction of credits

When negative inflation overshadows an economy, borrowing from banks and credit institutions decreases. As the value of assets such as housing falls, customers can not repay their loans on the same collateral. When the borrower does not repay the loan, the bank cannot repay all the money paid as a loan by the customer’s collateral. In such circumstances, governments lower interest rates to encourage people to borrow and spend.

Negative inflation solutions

Reducing the effects of negative inflation is possible, but combating this phenomenon requires a systematic approach and does not correct itself. Before it happens «The Great RecessionIn the 1930s, negative inflation was thought to have a period of self-perpetuation. However, economists emphasize that government intervention is necessary to prevent an anti-inflationary spiral.

During the Great Depression, the US government used a variety of methods to combat negative inflation, most of which were ineffective. For example, the then President of the United States, Franklin Roosevelt, believed that negative inflation was due to the high resources of goods and services, so he sought to reduce resources from the market. One of his actions was to buy agricultural land, with the aim of preventing farmers from producing agricultural products that fit the needs of the market. Some of these measures, instead of being a solution, damaged the economy and accelerated the anti-inflationary spiral.

Central banks play a major role in inflation and negative inflation due to the control of monetary reserves. For example, one way for central banks to eliminate negative inflation is A little relief Is. Although injecting large amounts of money into the economy can cause severe inflation, it is helpful to inject the right amount that can slightly increase the inflation rate to 1 to 4 percent.

The biggest limitation of central banks in controlling negative inflation is that they can only raise interest rates to near zero or a maximum of zero. If interest rates fall below zero, they will pose greater risks to the economy than negative inflation.

Historical examples of negative inflation

Although negative inflation is a rare phenomenon for an economy, we have seen periods of negative inflation many, many times throughout history. However, some of them were bigger and worse than others:

The spread of the industrial revolution

By the end of the nineteenth century, the growth of industrial technology had led to a sharp increase in production, resulting in a significant increase in commodity stocks. This reduced the value of the goods. While the Industrial Revolution brought great progress to mankind, it also led to periods of negative inflation.

The Great Recession

The Great Depression can be considered the most difficult period in the history of the American economy. Unemployment peaked during this period, and stock markets were razed to the ground. Because the dollar was backed by gold at the time, the US government could not print money to solve the budget deficit problem, and people refused to spend their money. The negative inflation during the Great Depression was such that housing and commodity prices were falling by the hour.

What is Deflation and what are its effects on the economy?
Queues of unemployed people during the Great Depression

Years after the First and Second World Wars

After the First and Second World Wars, especially World War I, many countries experienced negative inflation in the post-war period. The fires of war subsided, causing property prices to fall, and the return of millions of soldiers to civilian life, which led to increased demand for labor and drastically reduced wages. Such factors, along with government budget deficits for construction, led to negative inflation. Remember that because of the countries’ adherence to the gold standard, governments had their hands full in printing money.

Europe Debt Crisis

The debt crisis in Europe, which peaked in the early 2010s, caused problems for the world economy. To address this crisis, European governments have implemented austerity policies in their countries and cut government subsidies to students and families in need. On the other hand, the contractionary policies of central banks reduced monetary reserves in European countries. The main crisis ended in 2012, but its effects are still visible in countries such as Spain and Greece.


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