Essay on Deflation: Causes, Effects and Control | Price Fluctuations | Economics

Essay on Deflation: Causes, Effects and Control!

Essay on the Meaning and Causes of Deflation:

Deflation is the opposite of inflation. Just as inflation is a phenomenon of rising prices, deflation is a phenomenon of falling prices. In the words of Crowther, “Deflation is that state of the economy where the value of money is rising or the prices are falling.” No doubt deflation is associated with falling prices, but it is not that each and every fall in price will be termed as deflation.

Only those falls in prices which result in unemployment, overproduction and fall in the economic activity are deflationary. In short, deflation is a situation in which falling prices are accompanied by falling levels of employment, output and income.

Causes of Deflation:

Deflation is a situation in which falling prices are accompanied by falling levels of employment, income and output. Deflation may be due to certain natural causes, or it may be due to a deliberate policy of the government.

The following are the important causes of deflation:

1. Keynes’ Explanation:

Keynes had developed a systematic theory to explain the causes of deflation (or depression).

(i) Deficient Aggregate Demand:

The main reason for deflation is the deficiency of aggregate demand which leads to over-production and unemployment. Aggregate demand consists of aggregate consumption expenditure and aggregate investment expenditure.

(ii) Less Investment Expenditure:

Private investment is governed by marginal efficiency of capital (MEC) and rate of interest. Deflation is the result of decline in investment which is due to (a) low MEC or low profitability of capital and (b) high rate of interest.

(iii) Fall in MEC:

As the process of economic expansion goes on, certain forces come into operation which exerts downward pressures on MEC.

These forces are:

(a) During the process of expansion costs of production start rising on account of the increasing scarcities of materials and equipment. Wage cost also rises because of scarcity of labour. Rising costs have the depressing effect on MEC.

(b) Increasing abundance of output resulting from industrial expansion leads to lessen the returns below expectations which also depress MEC.

(iv) Less Consumption:

The basic cause of deflation or depression lies in Keynes’ concept of consumption function or his psychological law of consumption. According to this law, the consumers do not spend the whole of the increment of their incomes on consumer goods.

As the income increases, the community spends a smaller proportion of its increased income on consumer goods. The reduced sale of consumer goods leads to the accumulation of stock of consumer goods (or overproduction). This also has adverse effect on business expectations and MEC.

(v) Rise in Rate of Interest:

The fall in the MEC is followed by a rise in demand for money or rise in liquidity preference (i.e., the tendency of the people to keep money in cash form). No one likes to purchase goods or securities when the prices are falling. Given the supply of money, increase in liquidity preference results in the rise in the rate of interest which also reduces investment.

To sum up, according to Keynes, rising rate of interest, declining MEC, falling tendency of consumption- all these factors lead to reduce aggregate demand which ultimately result in deflationary conditions in the economy.

2. Contractionary Monetary Policy:

When the government adopts a contractionary monetary policy, it makes the availability of credit more costly by raising the rate of interest and reducing the supply of money. This results in fall in prices. Various contractionary monetary measures are- raising the bank rate, sale of government securities, raising the cash reserve ratio, reducing the currency, etc.

3. Reduction in Government Expenditure:

If the government decides to reduce public expenditure, it will reduce national income and employment multiple times (through the adverse working of multiplier). This will reduce aggregate demand, discourage investment and affect the economic activity of the economy adversely.

4. Heavy Taxes:

Heavy taxes imposed by the government reduce the disposable income with the people. This leads to the decline in both consumption and investment expenditure and results in deflationary conditions.

5. Increasing Economic Inequalities:

Increasing inequalities of income and wealth make the rich more rich and the poor more poor. Since the marginal propensity to consume (MPC) of the rich is less than that of the poor, growing inequalities of income will reduce consumption expenditure and will lead to deflationary situation.

6. Public Borrowing:

When the government borrows from the public, it results in the transfer of money from the public to the government. This reduces aggregate demand and brings deflation in the economy.

7. Psychological Factors:

Some economists feel that deflation and depression are the result of waves of optimism and pessimism. During the optimistic conditions of boom, they make over- investment. As a consequence, they fail to find buyers for their products, suffer losses, grow pessimistic about the prospects of business and curtail their productive activities. Thus, the discovery of error of optimism gives birth to the opposite error of pessimism.

8. Other Factors:

Some other non-economic and non-monetary factors, such as, wars, earth quakes, strikes, crop failures, etc. may also cause deflationary conditions.

Essay on the Effects of Deflation:

Deflation affects all aspects (i.e., economic, social and political) of the life of the country.

Various effects of deflation are discussed below:

(A) Effects on Different Sections of Society:

Deflation influences different sections of the society in the following manner:

1. Producers:

Deflation adversely affects the producers:

(a) During deflation, production costs do not fall as rapidly as the prices of finished goods,

(b) When the producer buys raw material and other inputs, he pays a higher price, but by the time he reached the market to sell his finished products, the prices of raw materials will fall because of deflation. Thus the producer will be forced to sell his products at a lower price.

(c) The demand for commodities goes on falling due deflation.

As a result of this the profits of the producer will fall and there will be overproduction of the commodities. Similarly, deflation also adversely affects the farmers, particularly the small farmers.

2. Traders:

The traders are also adversely, affected during deflation. When they make purchases, they have to pay higher prices, but when they sell the products prices fall due to deflationary trend. As a result, the traders are likely to lose.

3. Investors:

Different types of investors are affected differently due to deflation:

(a) The fixed-income investors (like debenture and bond holders) gain by deflation because incomes remain constant while the prices fall.

(b) The variable income investors (like equity holders) will lose during depression, because their incomes fall with the falling prices.

4. Salaried and Labour Classes:

Wage earners and salaried persons gain during deflation. The reason is that with the fall in prices, the wages and salaries cannot be reduced; such attempts will be strongly opposed by the trade unions.

5. Consumers:

The consumers generally gain due to falling prices because the purchasing power of their money rises.

Consumers are of two types:

(a) The consumers whose income remains fixed (i.e, salaried persons) will be benefited by deflation.

(b) The consumers whose income falls during deflation (e.g., profit earners) may lose during deflation.

6. Creditors and Debtors:

During deflation, the prices fall and the value of money rises. As a result, the creditors tend to gain and the debtors tend to lose.

(B) Other Effects on the Economy:

Deflation also affects the general life of the economy in the following way:

(i) Tax-payers are adversely affected in the deflationary period because due to falling prices, the value of money rises and the real burden of taxation increases.

(ii) The government faces an increase in the real burden of public debt.

(iii) Due to falling prices and profits, the entrepreneurs reduce output. Some small businesses may close down. This results in the unemployment of workers and employees.

(iv) Banking business also suffers during deflation because the number of borrowers falls sharply due to general recession in the economy.

(v) Like the private sector units, the public sector enterprises also suffer losses during deflation when the prices fall.

(vi) Deflationary conditions lead to greater number of industrial disputes and thus create industrial unrest in the economy.

(vii) During deflation, the pace of economic growth slows down or even suffers a setback and the economic, social and political life of the country get disturbed.

In short, deflation is even worse than inflation. Middle class people gain at the expense of the richer classes. Reduction in output and wide-spread unemployment adversely affect the economic life of the country and lead to social unrest.

Essay on the Control of Deflation:

To fight deflation, attempts must be made to raise the volume of aggregate effective demand. It will increase output, income and employment in the economy, Effective demand can be increased partly by encouraging consumption expenditure and partly by increasing investment expenditure.

Various measures can be taken to increase consumption and investment expenditures in the economy:

1. Reduction in Taxation:

The government should reduce the number and burden of various taxes levied on commodities. This will increase the purchasing power of the people. As a result, the demand for goods and services will increase. Moreover, sufficient tax relief should be given to businessmen to encourage investment.

2. Redistribution of Income:

Marginal propensity to consume can be raised by a redistribution of income and wealth from the rich to the poor. Since the marginal propensity to consume of the poor is high and that of the rich is low, such a measure will help increasing the aggregate demand in the economy.

3. Repayment of Public Debt:

During deflation period, the government can repay the old public debts. This will increase the purchasing power of the people and push up effective demand.

4. Subsidies:

The government should give subsidies to induce the businessmen to increase investment.

5. Public Works Programme:

The government should also directly undertake public works programme and thus increase expenditure in public sector. Care should, however, be taken that the public works policy of the government does not adversely affect investment in the private sector; it should supplement, and not supplant, private investment.

For this, it is important that only those projects should be selected for the government’s public works policies which are either too big or not so profitable to attract private investment.

6. Deficit Financing:

In order to have significant expansionary effects, the government’s public works schemes should be financed by the method of deficit financing, i.e., by printing new money. The government should adopt a budgetary deficit (excess of government expenditure over its revenue) and cover this deficit through deficit financing.

Deficit financing makes available to the government sufficient resources for its developmental programmes without adversely affecting investment in the private sector.

7. Reduction in Interest Rate:

By adopting a cheap money policy, the monetary authority of a country reduces the interest rate which stimulates investment and thereby expands economic activity in the economy.

8. Credit Expansion:

The central bank and the commercial banks should adopt a policy of credit expansion to promote business and industry in the country. Bank credit should be made easily available to the entrepreneurs for productive purposes.

9. Foreign Trade Policy:

To control deflation, the government should adopt such a foreign trade policy that, on the one hand, increases exports, and, on the other hand, reduces imports. This kind of policy will go a long way in solving the problem of overproduction, and help overcoming deflation.

10. Regulation of Production:

Production in the economy should be regulated in such a way that the problem of over-production does not arise. Attempts should be made to adjust production with the existing demand to avoid over-production.

In short, fiscal policy alone or monetary policy alone is not sufficient to check deflation in an economy. A proper co- ordination of fiscal, monetary and other measures is essential to effectively deal with the deflationary situation.