Deflation - Why Don't Prices Decline During a Recession Introduction Deflation and inflation are two reverse sides of the same coin. Before discussing the behavior of prices during recession, it is important to know inflation and deflation. Deflation happens when prices are reducing over time. In other words when the inflation rate is negative, the economy is experiencing a time of deflation. Definitions According to the Glossary of Economics Terms, deflation happens “when prices are declining over time. This is the opposite of inflation; when the inflation rate (by some measure) is negative, the economy is in a deflationary period" (Moffat 2010).
To know deflation, first we need to know inflation. Both are Latin words used for expansion and contraction of money from the market and economy. Generally, there is a price rise in inflation whatever the cause is; we cannot specifically name a cause and reasoning is not clear behind the occurrence of inflation. Similarly, deflation causing reduction in prices occurs not due to a single reason (Crisismaven 2010). There is logic behind the occurrence of inflation, which is that in comparison to products, money becomes comparatively less valuable in an economy.
As deflation is just opposite term to inflation, money becomes comparatively more valuable than other products in the economy. This logic leads to a combination of four reasons for deflation to take place. 1. The supply of money reduces. 2. The supply of other goods increases. 3. Demand for money increases. 4. Demand for other goods decreases. Deflation normally happens when the supply of products increases more quickly than the supply of money which applies to the above reasons.
These reasons illustrate why prices of some products increase over time while some other products’ prices decrease over time. Take for example the case of personal computers. Their prices have come down drastically over the past fifteen years. It is because of technological progress that PCs supply has overtaken the ride of demand of the product or supply of money (Moffat 2010). The four reasons stated above to describe deflation, the reason no. 4 pertaining to decrease in the demand of products, it is assumed that demand for products decreases speedier than the supply of goods increases.
So reason no. 4 should comparatively outweigh reason no. 2. Thus, Prices should fall expecting other things being equal (Moffat 2010). As we know that the economic indicators help in knowing the present and future economic trends, the Implicit Price Deflator for GDP are pro-cyclical coincident economic indicators. Therefore, the inflation rate is up during boom time and down during recession. This indicates the inflation trend -- to be higher during boom period than in down time.
But the question is why it is that inflation rate is still higher in recession. It means that prices are not going down while market is in recession (Moffat 2010). It is because our assumption that all things being equal is wrong. The money supply is uninterruptedly increasing. Therefore, there is a regular inflationary flow. Actually money supply can be M1, M2 or M3, as shown in the table of Federal Reserve. We need to know how much the per capita money supply in the U. S.
is. To show it by example, as we know America has faced the worst recession since Second World War from November 1973 to March 1975, as actual GDP came down by 4.9 percent. It should have created deflation but for the reason that money supply remained volatile during this time; the seasonally adjusted M2 increased 16.5% and the seasonally adjusted M3 increased 24.4%. The Consumer Price Index (CPI) increased 14.68% at the time when recession was high. Such a phenomenon is called stagflation when during recession inflation rate is high, a notion made popular by Milton Friedman.
It is observed that when inflation is normally less due to the recession impact, level of inflation remains still high as the money supply grows uninterrupted (Moffat 2010). Deflation is deadly In the current economic context residential costs – mainly the expense of renting or possessing a home – have been the main reason in restraining inflation. It is but natural to happen as residential costs make about one-third of the consumer price index. It has prompted some analysts like James Bianco of Chicago-based Bianco Research to state that inflation has got out of sync by going downward because of housing fiasco and its after-effects (Miller, 2010). Housing costs are not the only reason of deflation.
Prices of about 44% of the products and services that come under the preview of the government’s personal consumption expenditure price index came down in December. As per the index, rather than housing fiasco, CPI was better measure of inflation (Miller, 2010). For investors inflation is like good news as the CPI went up by 0.2% in January. The ‘D’ of deflation is a deadly word for investors, as they fear its return.
According to Michael Feroli, an economist at JP Morgan Chase, "Recent declarations of 'mission accomplished' in the fight against deflation risks now look somewhat premature. ” Price decrease at large scale can drain the economy. Consumers prefer to keep their cash intact in stead of spending it in the hope that the prices would come down the next day (Miller, 2010). The reaction to deflation can be both comforting and worrisome. The last time when the monthly core prices took down turn in December 1982, it was cheered by all because the end of the year timing of inflation prior to deflation was registered at 6.2% after giving a reading of 10.3% in 1981 but the latest decline in January has happened when inflation was quite low already.
So it is the perspective on the previous time that changes people’s outlook on deflationary and inflationary trends (Miller, 2010). Price-Deflation & Product Sales Price deflation actually ‘spurs’ sales, we see in the computer industry prices are decreasing continuously but people are not waiting for the next day to let deflation reduce the prices more.
Although new functionality features get added to the new products and their quality is also better than previously sold computers. Likewise, the same trend is seen in automobile industry. In stead of waiting for the new models to arrive, they go out to make a purchase. Actually sale of computers has been increasing with the time irrespective of the market condition, whether it is inflation or deflation; buyers are buying in deflation and sellers are selling in inflation (CrisisMaven 2010). Deflation & Recession Going back in history at the end of the nineteenth century, prices came down because of increased productivity.
It was a sign of growth, not economic downtime. Deflation of today is similar to the infamous 1930s than that of a softer type earlier, as demand is not strong enough and households and companies are afflicted with debt. During deflation, the nominal value of debts remains unchanged although wages, prices, and profit levels come down. Actual debt increases affecting borrowers’ capacity to spend. They reduce their spending to pay their debts.
It negatively impacts the financial set up and let recession firmly holds the economy (Welkerswikinomics 2009). During the deflation of 1929 to 1933, prices came down by 27%. Now, central banks are reducing interest rates to or near to zero in America, Britain, Japan, and Switzerland to control the situation from going out of hand (Welkerswikinomics 2009). Conclusion There could be many other factors other than prices, demand and supply that affect economy and trends. In deflation, prices are affected by a number of other factors, which are taken for granted to be equal.
So the conclusion is that rate of inflation goes up during boom and comes down during recession but it normally never crosses the zero mark because of regular increase in money supply. In other words, the rate of deflation goes up during recession but it is not applicable in all market conditions, as other assumptions don’t imply. Works Cited CrisisMaven. “If buyers don’t buy during a period of deflation why would sellers sell during periods of inflation? ” Economic Fallacy IV: Buyers’ Strike during Deflation? (21 March 2010). 10 April 2010 . Miller, Rich.
“Deflation: Why the 'D' Word Is Back on the Table” BW Magazine (25 February 2010). 10 April 2010 . Moffat, Mike. “Why Don't Prices Decline During A Recession? The Link Between The Business Cycle and Inflation. ” Economics (2010) 10 April 2010 . Welker, Jason. “Deflation: why lower prices spell doom for any economy! ” Welkerswikinomics (13 May 2009). 10 April 2010 .