When the price of goods and services decreases, it is called deflation.
Deflation increases the purchasing power of money.
It is the just opposite of inflation.
In most cases, a reduction in money supply or credit availability is the reason for deflation.
In the deflation time, the government reduces capital investment by government and individuals.
Deflation increases the problem of unemployment due to slack in demand.
The central bank keeps the overall price level stable by avoiding situations at the time of deflation and inflation.
The bank may infuse (fill) a higher money supply into the economy to counter-balance the deflationary impact.
In most cases, depression occurs when the supply of goods is more than money.
According to Crowther, “Deflation is that state of the economy where the value of money is rising or the prices are falling”.
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The main features or characteristics of deflation are:
Deflation refers to a continuous fall in price level over a period.
It is caused by action, reaction and counteraction between economic forces.
It is a situation at which investment, employment, output, income are falling continuously with the fall in price level.
It occurs when goods and services supply is greater than demand.
It is a process that causes deterioration in the results of companies.
Deflation limits the number of workers and investment in goods.
Demand is diminished by cuts.
Banks are unable to provide loans.
Businesses make less profit because of lower prices.
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Deflation occurs due to a decrease in aggregate demand or an increase in aggregate supply.
Deflation makes overproduction in the economy.
The produced goods are not sold in the market; as a result, producers decrease production.
The decrease in production decreases employment.
A decrease in employment decreases the income of people.
A decrease in income further decreases the aggregate demand for goods and services.
Thus, deflation has a spiral effect.
Fall in demand for goods and services are the primary cause of deflation.
People reduce their consumption of goods and services due to various reasons.
Due to decreases in the demand, the prices of goods start falling.
Sometimes people start saving,
It causes a reduction in aggregate demand.
Thus, the available supply is sold at falling prices.
When banks reduce loan disbursement, consumption and investment demand decreases.
The central bank may also tight monetary policy by increasing rates.
This makes a decrease in aggregate demand in the economy and deflation occurs.
Due to some reason, the level of investment in all economies is falling.
It will negatively affect the economy.
The demand for capital goods will fall and prices will tend to come down.
A decrease in incomes of the people can also cause deflation in the economy.
Due to a reduction in the income level of the people, the aggregate demand for goods services falls short of the aggregate supply.
Thus, prices start falling.
When aggregate supply increases due to various reasons, deflation occurs.
In this case, the aggregate supply will exceed the aggregate demand.
Hence, increases in aggregate supply will fall the price level.
An increase in tax decreases the disposable income of people.
It decreases aggregate demand.
Due to increases in the tax, deflation occurs.
Sometimes decline in the price is due to a decrease in production cost.
When the production cost decreases, the producers will be able to increase production output.
More production means oversupply in the economy.
Thus, lower production cost also causes of deflation.
New technologies in production can cause an increase in aggregate supply.
Technological advances will allow producers to lower costs.
Thus, the prices of products will likely go down.
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Deflation comes together with depression.
During the depression, total output decreases sharply, employment decreases at mass level and poverty increases.
Deflation affects all aspects of the life of the country i.e. economic, social and political.
Deflation affects producers, traders, investors, equity holders, employees, consumers and so on.
Various effects of deflation are discussed below:
At the time of deflation, businesses drastically reduce the prices of their products or services to stay profitable.
Deflation decreases the price of goods and services.
It reduces the business revenues of producers and traders.
Deflation is connected with an increase in interest rates.
Deflation causes an increase in the real value of debt but the fixed interest does not change.
As a result, fixed-income investors like debenture and bondholders are likely to postpone their investments.
During deflation, prices of goods and services decrease.
Decreasing the prices of goods and services also decrease the revenues of the company.
Decreases in revenue of the company effects the dividend rate.
The variable income investors like equity holders will lose during deflation.
Because their incomes fall with the falling of the prices of goods and services.
During deflation, the unemployment rate will rise.
During deflation, the price level decreases.
The producers tend to cut their costs by laying off (terminating) their employees.
Thus, deflation increases unemployment.
Deflation is a situation where decreasing price levels trigger (activate) a chain reaction
Deflation leads to lower production, lower wages, decreased demand, and even lower price levels.
During a recession, the deflation spiral is a significant economic challenge because it further worsens the economic situation.
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