A simple definition of economics would define deflation as a situation where the prices of goods and services fall during a particular period of time. Mathematical interpretations would mean that deflation is a situation where the inflation level falls below 0%. However one should not confuse this term with disinflation which is a situation where there is a slowdown of the inflation rates. As we know that inflation reduces the value of money over a period of time conversely deflation increases the real value of money. It means that one can buy more goods at the same amount of spending that they used to do previously.
What are the causes of deflation?
There are several reasons which could lead to a deflation scenario in an economy. But two of the most accepted reasons by the economists are:
- Consumption supply and demand curve showing a downswing i.e. people of the country are not buying products or services. It can have two main reasons for it. One could be that people are short of their disposable income as well as savings, in simpler terms they do not have money. Second reason could be that people are short of money due to reasons such as unemployment for at least a year.
- The other accepted reason is that is the presence of low central bank interest rates. The RBI controls the inflation or the deflation rates by changing interest rates in order to control the circulation of money in the markets. They do it by making loans cheaper or expensive as a step to curb down the unwanted scenario.
So how does deflation impact our investments?
Since the Great depression in the early 19th century the world has not really seen a deflationary situation in a big way. One might infer out of a deflationary situation as a good one as goods and services are available at cheaper rates. But the direct reason for the drop is the decreased demand for a particular good or a service. This in turn would also mean that employers take steps to cut down their expenses such as wages, which indirectly would reflect in a lower consumer spending.
On a broader scale it would reflect in the earnings of a company which is bound to come down if a situation of deflation exists. This would mean the company curbs its costs to fight out the reduced profits. It would definitely mean that the investors would loose money as the equity prices would start falling. Until and unless the government steps in to lower the interest rate to stimulate the economy the equity prices would continue to get the beating. However in a deflationary scenario the fixed income securities look attractive such as bonds.
Knowing how deflation could affect our lives and investments we may now feel that deflation is worse than inflation. At the time of inflation the government takes measures to promote savings by increasing the interest rates as a measure to curb down the spending levels prevailing. However in a deflation the government does the opposite whereby they would promote spending and reduce the interest rates. But in any way they cannot reduce to a negative level or below zero.
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Mohan Bhupathiraju
Mohan Bhupathiraju is a co-founder & editor at LastBull.com. Handled multiple projects in BFSI for few of the Forbes top 100 companies. He works in IT industry in the US. Presently working on start up Ideas in Finance & Technology niches.
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{ 2 comments… read them below or add one }
Inflation and deflation are opposite to each other. Both can be damaging to the economy if they are at excessive levels.Therefore a balance in Economy is must.
Yes, Balance should be maintained.