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Deflation: Friend or Foe?
According to Investorwords.com the definition of Deflation is "a decline in general price levels, often caused by a reduction in the supply of money or credit. Deflation can also be brought about by direct contractions in spending, either in the form of a reduction in government spending, personal spending or investment spending. Deflation has often had the side effect of increasing unemployment in an economy, since the process often leads to a lower level of demand in the economy. The opposite of inflation."
What Causes Deflation?
Although everything said above is true, it doesn't present the true nature of deflation. It tries to define it by presenting several possible causes. For a true understanding of both Inflation and Deflation we need to understand Supply and Demand. Just like every other commodity, there is a supply of and a demand for "Money".
It is beyond the scope of this Acorn to go into the economic definition of "money", so for now we will simply define it as something other people are willing to accept in exchange for goods or services.
Price levels are the direct result of the relationship between the supply and the demand for any given item. But the value of the money used to pay for those items is also subject to the same relationship.
For the sake of simplicity let's assume that we are on an island and there are ten equally desirable goods in our universe and ten $1.00 bills available to purchase them with. We can safely assume that each item will end up costing $1.00.
If the quantity of money somehow increases to $20 (without increasing the quantity of goods) the price of the goods will increase to $2.00 - that is inflation.
If, however, the quantity of money decreases to $5.00, the price will fall to 50¢ (deflation). This is what the first part of the above definition is referring to. The money supply can also be reduced if someone on our island hoards half of it and refuses to spend it on anything, no matter what. This is the second part of the definition (reduction in spending).
That is one part of the equation, the supply of money. But what happens if the quantity of goods available increases? What if, instead of having 10 items we build 10 more? (Don't ask anything embarrassing like how we got the money to build 10 more. We're trying to keep it simple here.) We now have 20 items and only $10.00 so once again each item is worth 50¢. This form of deflation is the good type.
Everyone assumes that deflation is bad because the last major deflation that we had was during the "Great Depression" so deflation and Depression are synonymous in many peoples' minds. In actuality, if prices go down because the goods can be manufactured more cheaply, this ends up increasing everyone's wealth.
That is exactly what happened in the technology boom of the 1990s. Better technology led to increased productivity which increased the quantity of goods at a faster rate than the money supply. Wealth was created at the same time that prices declined. Everyone benefited.
What about Demand?
What about the demand for goods? If everyone on our island already has one of the items available and no one needs any more, naturally the price will also fall as sellers try to find someone to take them off their hands.
That's simple enough to understand, but what about the demand for money? Is it possible for the demand for money to increase or decrease? Sure it is. The demand for money is measured by how much people are willing to pay for it as reflected in interest rates. If demand for money increases and the supply remains constant, interest rates will rise. If the money supply increases at the same time and at the same rate, interest rates will remain the same. If the demand for money falls, interest rates will also fall, again assuming no change in supply.
So there are four causes for Deflation.
- Decreasing Money Supply
- Increasing Supply of Goods
- Decreasing Demand for Goods
- Increasing Demand for Money
Note:
Increasing demand or decreasing supply of money have the same result, i.e. "tight money". Either way, people want more money than is available.
Both could also result in (or cause) higher interest rates. But the higher interest rates should also tend to balance (or decrease) the demand for money because it is now more expensive.
In other words, as interest rates rise, at some point the demand drops off because people don't want it badly enough to pay such high rates.
Is Deflation Good or Bad?
Actually, deflation itself is neither good nor bad. It is the cause of the deflation that determines whether people will suffer or rejoice. If the cause is the increasing supply of goods, that's a good thing.
However, if deflation is caused by a decreasing supply of money as in the Great Depression, that would be bad. The stock market crash sucked all the liquidity out of the market place; the economy contracted; people lost their jobs; and then banks stopped lending money because people were defaulting. The problem compounded as more people lost their jobs and money supply fell further causing more people to lose their jobs, etc. etc.
It is this kind of deflation that everyone seems to be talking about today and that has investors on edge. It is also one reason for the current popularity of bonds at any price. Of course, no one (including us) really knows for certain if we will have deflation, but we can't rule it out and our portfolios are currently positioned accordingly, i.e. diversified.
We hope that this information will help you better understand today's headlines. As always, we appreciate your comments and suggestions, but most of all your confidence and trust.
