In developing, growing nations such as India, The Central Bank is usually preoccupied with controlling inflation. It doesn’t usually encounter the problem of deflation. Developed nations like Japan on the other hand, have been grappling with deflation for a while. Persistent deflation is undesirable, destructive even. Let’s see why.
1. Deflation causes people to delay Consumption spending because they expect prices to fall further. Why buy now, when the dollars you hold today will become more valuable in the future and allow you to buy more goods? Since the public delays spending, consumption spend falls, which leads to reduced sales at businesses. This leads to production cuts and worker lay-offs (output and employment fall). When this happens, demand gets even more depressed.
2. What makes the situation worse is that people avoid Borrowing as well. Let’s explain with an example involving two scenarios. 1) A business borrows Rs. 100 for one year when prices are rising (+2%), at a nominal interest rate of 5% (real interest rate of 3% + inflation of 2%). 2) The same business borrows Rs. 100 when prices are falling (-2%), at a nominal interest rate of 1% (real interest rate of 3% + inflation of -2%).
In the first case, output that the business sold for Rs. 100 when it took the loan, is sold for Rs. 102 a year later, when it is time to repay the loan (we assume that market price for the business’s end product also rises by 2% in line with the general price level). So what’s left to be paid is = Rs. 3 = Rs. 105 -102.
In the second case, output that the business sold for Rs. 100 when it took the loan, is sold for Rs 98 a year later, when it's time for repayment (we assume 2% price fall for the business’s products as well). So what’s left to be paid is once again = Rs 3 = Rs 101 - 98.
But repaying Rs 3 is much harder when prices have fallen, vs. when prices have risen. When prices fall, what the business sold for Rs 3 when it look the loan (a year earlier), can now be sold only for Rs. 2.94 (deflation of 2%). When prices rise, what the business sold for Rs 3 when it accepted the loan, can now be sold for Rs. 3.06 (inflation of 2%). The “real” burden of the debt is much higher when prices fall.
As a result, people are loath to borrowing money when deflation is rampant. They fear they won’t be able to repay.
3. Unwillingness to borrow means Investment spending falls. In a deflationary environment, lowering interest rates is often ineffective in boosting investment spend.
We’ve already seen how people avoid borrowing when prices are falling. Since borrowing is the predominant method of financing investment, this leads to a drop in investment spend (reinforcing the drop in consumption spending). Usually when investment spend is anemic, the government lowers interest rates to give investment spending a boost. In a deflationary environment however, interest rates can become ineffective in boosting investment demand.
Let me explain. The nominal interest rate (rate at which borrowers lend) is the sum of two rates, 1) the “real interest rate” - the reward for bearing the risk of lending, and 2) inflation. When there is deflation, nominal interest rates tend to be low. For instance, if the real interest rate is = 3% and inflation is -2%, the nominal interest rate is just 1%.
The public may already be wary of borrowing even at this low rate of 1% because of the reason explained above. What happens if the nominal interest rate is lowered to 0%? Investment may still not rise. The public’s fear of the increased “real” burden of their debt in an economy where output and prices are falling may continue to hold them back from borrowing even at a 0% interest rate!
(Note: the nominal interest rate cannot fall below 0% because if it does, lenders will not lend anymore. They’d rather just sit on their capital and preserve its nominal value).
4. The drop in Consumption and Investment spending coupled with the ineffectiveness of interest rates cuts in raising Investment demand, can lead to the dreaded “Deflationary Trap”.
Deflation causes Consumption and Investment spending to fall. Lower interest rates are unable to boost investment spend. Lower spending leads to cuts in output and worker layoffs/unemployment. This leads to further decreases in demand and spending. This causes prices to fall further.
What I have described above is the dreaded “deflationary spiral” or “deflationary trap” where deflation begets deflation. It become hard to escape this vicious cycle and economies can get trapped here for a long time. Japan for example has been battling deflation since the mid-1990s.
5. Persistent deflation can be more dangerous than inflation. Inflation can be tackled with interest rate hikes etc., but once deflation sets in, it can be hard for the economy to escape. As we’ve explained above, the interest rate mechanism often fails to work.
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