Terms Beginning With 'd'

Deflation

  • January 11, 2020
  • Team Kalkine

What is meant by deflation?

Deflation refers to the fall in prices of goods and services in an economy. Deflation increases the purchasing power of a currency as goods become cheaper than usual. Deflation is the opposite of an inflationary scenario, where prices of goods and services in an economy rise.

Deflation generally indicates a highly productive economy but decreasing prices could also point towards a contraction of demand. Deflation can also lead to a financial crisis as the prices could crash down to unforeseen levels.

To some degree, deflation helps in increasing consumer spending, and it allows domestic consumers to purchase a higher quantity of products for the same price as before. On the contrary, deflation can sometimes be a sign of an impending recession. The speculation of an incoming recession may urge consumers to save more today, which can lead to a further contraction in demand.  

What are the causes of deflation?

Two macroeconomic factors can cause deflation:

  1. Decline in Aggregate Demand: Aggregate demand (AD) refers to the total demand for all goods and services in a country. A drop in demand has a direct relation to an increase in prices. As demand falls, there is not enough consumption to meet the supply in the economy.
  2. Increase in Aggregate Supply: Aggregate supply (AS) refers to the total supply of goods and services available in a country. For the same reason as explained above, when the supply exceeds the demand, the prices decline. On a broader scale, deflation is caused by the disequilibrium in the AD-AS model.

Deflation is the economic state where the money supply in the economy remains the same, but the population and the economy both expand. Therefore, to maintain equilibrium, the amount of cash in an individual’s portfolio decreases. This leads to an overall increase in the value of the currency, unlike in inflation.

Deflation is the scarcity of hard cash in an economy which makes it more valuable to hold.

The scenario of deflation can also occur when the productive efficiency of a nation increases due to better technology. Higher competitiveness levels also lead to firms lowering their prices as they save up on their costs. As prices are lowered, consumers are left with more cash in their portfolio, and thus deflation occurs.

What are the economic impacts of deflation?

Deflation can lead to the following macroeconomic impacts:

  • Unemployment: As there is a lack of money in circulation, there is contracted demand. This may lead to producers further cutting down on their costs to save money. Thus, fewer workers are hired, and there are lesser jobs available.
  • Debt: Interest rates increase under the scenario of deflation. Therefore, it becomes riskier to borrow as the interest to be paid on borrowings increases. This leads to the situation of debt deflation wherein the real value of debt rises due to deflation.
  • Deflationary Spiral: This refers to the scenario where lower prices lead to a further drop in prices. As prices fall, companies try to save up on their costs, leading to lower production. As a result, lower salaries are offered to the employees, and they are not able to spend on consumption. This leads to a further contraction of the economy as the demand falls, which again deflates the price levels.

Is deflation more harmful than inflation?

Inflation leads to an overall increase in the price levels, and thus goods become more expensive, and the value of the domestic currency falls. However, inflation may be beneficial in some cases as it helps reduce the burden of international debt. As the domestic currency loses its value, the foreign debt on a country also declines in real terms.

Unlike inflation, it is hard for consumers to protect themselves from deflation. People can invest and save enough money to ensure that they can combat the scenario of inflation. However, deflation poses a set of challenges for the consumers which are hard to get by and can be explosive at times. It can also put the economy under a liquidity trap, wherein people hoard money instead of investing it.

How can deflation be controlled?

Deflation can be controlled by the government using the following methods:

  • Boosting money supply: Increasing the supply of money by buying back bonds through open market operations. This would increase the value of the currency, thus leading to increased public spending.
  • Increasing borrowing: This can be done by lowering interest rates through monetary policy. As interest rates fall, people start borrowing, thus borrowed money is put into investments and the economy is revived again.
  • Favourable fiscal policy: Along with monetary policy changes, the central bank can also boost public spending by introducing appropriate fiscal measures. This includes tax cuts, fiscal aids and increasing public expenditure.

Is deflation overall a good economic scenario for a country?

Deflation can be more harmful than beneficial for an economy. If a country finds itself locked into a deflationary spiral, it becomes challenging to come out of it. Moreover, increased debt levels caused by deflation are hard to recover from, even with proper debt financing measures taken by the government. Financing debt, in the current period, may lead to increased debt burden in the future.

However, lower level of prices in an economy can also have positive connotations. It can be a sign of an efficient production set up in the economy facilitated by proper utilisation of resources. Economies that offer relatively cheaper goods are deemed to be highly competitive. An example is the computer hardware markets across the world. As new and fast production techniques become accessible across the globe, the price of the final output becomes lower internationally. Thus, there is deflation in the computer hardware markets.

Repo Rate is a banking term, which usually reflects the rate (or interest) central banks charge commercial banks to lend the money in the event of shortfalls of funds. Central banks also manage inflation by repo rate by increasing/ decreasing the repo rate at the times of higher inflation and deflation, respectively.

Value deflation unfolds when a seller provides a cost cut and sell in lower quantities in the form of smaller packages, i.e. provide less for the same price/value, with the intent of maintaining same selling price.

What is Meant by Devaluation? Devaluation refers to the act of deliberately decreasing the value of the domestic currency with respect to the currency of a trading partner. It is different from depreciation in the sense that it is done on purpose by the domestic monetary authority. The opposite of devaluation is revaluation, where the value of the domestic currency is deliberately increased. Countries having a fixed exchange rate system, or a semi-fixed exchange rate system can use devaluation. The decision to devalue or revalue the currency is taken by the central bank of a country or the monetary policy authority. How do Countries Devalue their Domestic Currency? Consider the following example showing the determination of the exchange rate of Dollar in terms of Euro. In other words, the exchange rate here represents the Dollar-Euro exchange rate. The supply of Euro refers to the quantity of Euro available as foreign exchange, while the demand for the Euro reflects its demand in the domestic country. Related Read on Forex Trading! Considering the above diagram, the supply of Euro in the economy is increasing, while the demand for Euro remains the same. As more and more units of Euro are accumulated as foreign exchange, Euro depreciates while Dollar appreciates. Now consider the following example when the domestic demand for Euro rises. Here the increased demand for Euro leads to Dollar depreciating with Euro appreciating. Thus, the Dollar-Euro exchange rate rises. Therefore, it is possible to change the value of the domestic currency with respect to foreign currency by changing the supply of foreign exchange reserves of the latter. This method is used by central banks of various countries to devalue or revalue their domestic currency. If the current exchange rate is maintained at 2:1, then the home country can just announce that the value of the domestic currency will be devalued to 10:1. This further decreases the value of the domestic currency. Why do Countries Decide to Devalue their Currency? Devaluing domestic currency decreases its value with respect to a foreign currency. This means that if previously, 20 Dollars could be bought in exchange for 1 unit of the domestic currency, after devaluation, one unit of domestic currency would be equal to less than 20 Dollars. Devaluation is a quick and risky way for countries to come out of debt. It is also done to boost exports, as the domestic goods become relatively cheaper as compared to the goods of the trading partner. Further, it makes imports more expensive, as the foreign currency seems to have gained value with respect to domestic currency. This urges domestic consumers to prefer domestic goods instead of imports. As imports fall and exports rise, the current account strengthens and deficits in the Balance of Payments can be recovered. Moreover, devaluation allows countries to make the domestic products competitive with respect to foreign produce. It offers an edge over internal devaluation which relies on implementing a deflationary policy. These advantages offered by devaluation can be misused by countries as they try to reduce the debt burden on them. As countries usually borrow from each other, the amount of interest that they must repay to the lenders depends not only on the interest rate but also on the foreign exchange rate. As the domestic currency becomes cheaper, the foreign country can repay a larger amount of debt with the same amount of foreign currency. For instance, as the USD becomes cheaper, the European nation can repay a larger amount of debt with the same amount of foreign currency. What are the Challenges Faced by the Economies which Devalue their Currency? Inflation: The biggest issue that arises because of devaluation is inflation. As the aggregate demand increases in the economy because goods become cheaper, demand-pull inflation takes its course. This may also lead to lack of productivity in firms as they enjoy price competitiveness due to devalued currency. Travel: Foreign travel is hampered as it becomes relatively more expensive to go on a foreign tour. This may affect the tourism industry in the home country along with the foreign country. Real Income: Inflation and devaluation both reduce the purchasing power of domestic consumers. Investment: Foreign investors would be wary of depositing funds in the home country as they would not enjoy the same amount of returns as before. How should Devaluation be Implemented? Under tight circumstances when a boost to aggregate output is much needed, then devaluation can be implemented. However, an economy that sees prolonged devaluation can be an underperforming economy. Devaluation is used as a regulation tool; however, if it is misused by one country, other countries might be tempted to retaliate. This could lead to a trade war, which would further be a threat to global economic growth. International asset market would take a hit, and it may lead to a global recession. The Year 2019 observed escalation of a trade war between the US and China. To Read More on the US-China Trade War, Click Here! The devaluation could prove to be more harmful than beneficial as it can cripple the domestic markets. Thus, implementing it for a short period of time could be a good solution; however, in the long run, other alternatives should be adopted.

What is Recession? Simply put, Recession is a macro-economic phenomenon characterised by a dip in economic activity, fall in aggregate demand and soaring unemployment levels for an extended period of time. Some experts define the onset of recession with the negative economic growth rate for two consecutive quarters, as Technical Recession. COVID-19 Pandemic Rang Bells of a Technical Recession Across the Globe in 2020 During a recession, the economy faces sluggish retail sales, crushed consumer confidence, dip in business sentiments, job losses, reduced manufacturing output and sales¸ with a decline in the nation’s overall GDP. What are the Leading Indicators of an Economic Recession? Economic monitoring agencies such as the National Bureau's Business Cycle Dating Committee maintains a chronology of U.S. business cycles in the forms of peaks and troughs. While the peak is defined as the month in which several macroeconomic indicators reach their highest level, a trough is identified as a month in which economic activity reaches a low point and begins to rise again for a sustained period. The period between a peak and a trough is a contraction or a recession, and the period between the trough and the peak is an expansion. Predicting future recessions is not an easy economic phenomenon, given a lot of uncertain factors involved in economic forecasting. However, economists monitor macroeconomic fundamentals to gauge the recession scenario. Below are some of the leading indicators of looming threats of economic recession: Negative Economic Growth Rate Yield-Curve Inversion Sharp Stock Market Declines Dip in Unemployment Asset Bubble Sudden Economic Shock Excessive Debt High Inflation Levels What were Chief Triggers Behind Previous Episodes of Recession? Because the US is the largest economy of the world and has robust financial and trade linkages with several other economies, most of these internationally synchronized recession outbreaks also coincide with the US’ recessions. Global Virus Crisis (February 2020 Beginning) - The NBER officially declared a U.S. recession due to coronavirus in June 2020, noting that the U.S. economy fell into contraction starting in February 2020. According to the World Bank, the COVID-19 recession seems to be worse than twice the depth of 2007-09 Global Financial Crisis and the deepest since 1945-46. Good Read: Three Unique Investment Tips to Build Recession-Proof Portfolio in COVID-19 Crisis Global Financial Crisis (2007-2009)- Following the unsustainable housing bubble and credit boom, a downturn in the US housing market proved to be a catalyst for the financial crisis that spread from the US to the rest of the world through financial system linkages. Excessive risk-taking in a favourable macroeconomic environment, increased borrowing by banks & investors and regulation and policy errors were considered as the key factors behind one of the deepest recessions post 1930s Great Depression.  The Dot-Com Recession (March 2001 to November 2001): A rampant excitement and investment into tech stocks terminated with a bang 20 years ago, when the dot-com bubble busted officially. With the easy and common access to world wide web in the mid to late 1990s, reckless fad investments were made by investors in technology stocks and internet-based companies, fuelling NASDAQ to record high levels of ~5,000 in the year 2000 from ~1,000 in the year 1995. While, the good times didn’t last, with NASDAQ crashing to ~1,100 by October 2002, wiping off 75 per cent of market value from the equity market. Consequently, the US economy suffered a dot-com bubble recession, which induced massive job losses in the tech sector, triggering repetitive rate cuts by the Federal Reserve.  The Gulf War Recession (July 1990 to March 1991): A steep increase in oil prices can be an indication of a recession, as evident during 1990 oil price shock when energy became expensive in response to the Iraqi invasion of Kuwait on August 2, 1990, pushing up the overall price level with a significant dip in aggregate demand.  Great Depression 1930s: Recognised as the only economic depression of the modern era, the Great Depression hit the world in 1930s, lasting from 1929 to 1939. The Great Depression initiated in the US, resulting in around 30 per cent fall in the nation’s real GDP and more than 24 per cent rise in the unemployment rate. The severity of this depression was evident from acute deflation, remarkable falls in output and terrible unemployment rates in almost every single country of the world. What are the Economic and Social Impacts of Recession? Previous episodes of recession have been seen to be giving a dent to social and economic considerations of the nations as outlined below: Economic Blow Weak Output Levels Rising Unemployment Rates Fall in income Lower levels of household spending and investment by businesses Fall in asset prices (e.g. fall in house prices/stock market) Higher government borrowings (less tax revenue) Financial and banking sector instability Social Blow Mental Stress amidst bankruptcies and business losses Sustainability fight amidst a rise in poverty, an increase in inequality Health problems and social issues such as suicides Impact on education affordability What are the Types of Recession and Recovery? While there is no specific classification system to define recession shapes, economists tend to refer to four key shapes of recession and the resultant economic recovery: V-Shaped Recession: Recessions that start with a sharp fall in economic growth but then discover a bottom and rebound strongly, are categorised under V-shaped recessions. U-shaped Recession: Recessions that commence with a relatively slower fall in economic growth but then stay at the bottom for multiple quarters before turning around and reviving are classified under U-shaped recession. W-Shaped Recession: Recessions which initially start like V-shaped recession but turn back down again after exhibiting false signs of recovery, demonstrating a ‘down up down dip’ shape akin to W are deemed to be W-Shaped Recessions. L-shaped Recession: Recessions in which economic growth quickly falls and fails to stand back are termed as L-shaped recessions. Though V-shaped recessions are considered to be a best-case scenario for an economy, L-shaped recessions, that offer no hope of economic revitalisation, are believed to be the worst case scenario. What is the Difference Between Recession and Depression? The key difference between recession and depression is usually marked by the duration and depth of an economic downturn. While a recession is characterized by a considerable dip in economic activity lasting for more than a few months in a more localized scenario, a depression is noted when an economic dip lasts for years, usually with a global reach. What are Feasible Responses to an Economic Recession? While recession casts a heavy blow to the nation/world’s economic, financial and social aspects, efficient policy responses play a crucial role in containing the downturn and charting out gradual recovery prospects. Some of the key policy responses are listed below: Monetary Push- Monetary authorities, in a bid to contain recession and aid dysfunctional markets, engage in Quantitative Easing i.e. purchasing long term securities in Open Market Operations, reduce interest rates, and lend money to the financial institution, thereby increasing the money supply. Fiscal Initiatives- Governments undertake key changes in tax norms, infrastructural investment and increased spending to support employment and aggregate demand. Robust Oversight of Financial Firms- In the face of crisis, regulators are often seen to be strengthening their supervision of banking and financial space in an attempt to prevent the risk spread. Read Through Some Investment Strategies to Build Recession-Proof Stocks

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