Deflation – lowering money supply and falling prices
Deflation is a gradual process. Deflation is the general persistent decline in price levels. It is therefore the counterpart to inflation, the general price increase. Deflation usually occurs in combination with an economic depression. Deflation describes the situation when aggregate demand is lower than aggregate supply. Deflation is therefore an impact of an economic downturn, as real economic purchasing power remains at a lower level than the supply guaranteed by the production of goods over a longer period of time. This creates an oversupply of goods on the market that is not in proportion to the (falling) demand.
Deflation – causes of deflation
The causes of deflation are diverse and affect a wide range of areas of business and politics. From an economic point of view, consumer and investment reluctance is one reason for deflation, as individuals fear an economic downturn that wages or conditions on the labor market will deteriorate. There are fears of existence that lead to cost-cutting measures and accordingly to lower consumption. Similar reluctance can also be observed in companies that reduce expenditure and investments to a minimum due to the decline in consumption. In addition to the decline in consumption, there is a generally falling total demand for goods with a relatively unchanged range of goods. Another economic cause is, for example, asset deflation, which occurs in combination with the bursting of speculative bubbles. This leads to a sudden reduction in asset prices, which lead to household overindebtedness and loan defaults. This shift in debt at the expense of the banks means that fewer new loans are granted than loans that expire or fail. The money supply is falling and with it the overall economic demand. However, politics can also be a source of deflation. If the government decides to cut government spending sharply due to a budget deficit, government demand in the markets will drop while supply remains unchanged. There is again a gap in demand.
Deflation – consequences of deflation
If goods and services continue to get cheaper, people, provided wages and salaries remain constant, will become relatively richer. Because of the existing assets you can afford more because of the falling prices. Deflation is the result of an extreme reduction in the money supply by the central bank responsible. The real economic effects of deflation are much stronger and more damaging than those of inflation. It is therefore not surprising that deflationary trends are much less common than inflationary trends. Deflation can have a real economic impact, for example, if companies cut production and cut wages or cut jobs. Rising unemployment sustainably increases the decline in consumption. Deflation is therefore an ever worsening trend unless countermeasures are taken.
Calculation example deflation
This calculation example illustrates deflation using the example of the MCB. This is about the monetary value or the money put into circulation by the MCB: (1) There are 1000 USD in circulation. (2) A bread costs 1 USD. (3) A man earns 50 USD, so he could buy 50 loaves of bread.
The central bank prints 20 USD less: there are now 980 USD. In order to be able to sell as much as before, the baker lowered the price of a bread to 0.98 USD. The man still earns 50 USD, but can now buy 51 loaves. His 50 USD are really worth more.