In a country like India which is battling inflation, you may not have heard the term ‘deflation’. Deflation is exactly opposite of inflation which means the prices of goods and services keep falling. This means you will able to buy more goods with the same amount of money. It sounds great, isn’t it? However, deflation can be more damaging to an economy than inflation.
There are a number of factors which can lead to deflation. One of the reasons is increased supply. Generally, fall in prices of goods is a function of demand and supply. If many players are supplying the same good, the prices of that particular good will fall.
Here’s what happens when an economy faces deflation:
Drop in consumer spending
The relationship between deflation and consumer spending is complex. When the economy is facing deflation, in the short run, consumers may take advantage of it by spending more. However, they would realize that prices could continue to fall further which could defer their spending. This dampens demand and companies are forced to cut prices to clear their inventory. As profitability decline, companies would be reluctant to make investments in new projects. This would in turn slow down investments in the economy and the cycle of deflation may get worse. With the fall in private investments, the government tends to increase its expenditure to spur demand.
In order to stay competitive, companies tend to reduce the prices of their products. This has a direct impact on their revenues.
Since the profitability of companies drop, they find ways to reduce their expenses to protect their bottom line. They can make these cuts by reducing wages and downsizing.
Reduction in investments
When the economy is facing deflation, investors may not invest in markets. This is because markets will not rise because companies would report lower profits which would eventually reflect in the share prices. Rather, investors would hold on cash or invest in fixed deposits to protect their capital.
To spur demand, central banks would pump in more money in the economy by reducing policy rates. This would make interest rates to go down. Thus, investors would earn even less in fixed deposits. This would make investors hold on to cash.
As prices decline and companies react to it by downsizing or reducing salaries, consumers may not be able to pay back their loans. If borrowers are unable pay back, lenders will be unable to recover their loans through foreclosures or property seizures. Fearing further bad loans, banks slow down lending which further dampens consumer demand.
Countries facing deflation
Japan is facing deflation since 1990s due to tight monetary conditions, unfavorable demographics and bad loans. The government tried to put the economy back on track by increasing the money supply. However, this did not yield the desired results. In January, The Bank of Japan adopted a negative interest rate policy to achieve its 2% inflation target.
Just like Japan, many other European countries like Greece, Croatia, Sweden, Poland and Spain are facing deflation. To sum up, the fear of deflation lowers investor confidence which is reflected in markets across the globe.