Recently, economists and the media have frequently raised the possibility of deflation. For most of us, this is a new concept, as periods of deflation are rare and few people have experienced such a phenomenon. Initially, many people will probably welcome such a scenario. At first sight, the economy seems to be offering us the best of both worlds: the price of consumer goods keeps on falling, which increases our purchasing power. Conversely, consumers dislike inflation, because rising prices produce the exact opposite effect.
During periods of inflation, people feel wealthier because the price of the durable goods they own keeps on rising. They get an urge to spend now, before prices go even higher. And businesses are motivated to invest in production, because inflation guarantees that the final price of their products will justify the investment.
Deflation produces the exact opposite effect and hurts the most vital aspect of the economy: consumption. Consumer spending is the engine of economic growth, and when it is stagnant, corporate profits suffer and businesses have trouble paying their employees’ wages. This quickly creates a vicious cycle: in fact, why should consumers spend less while their purchasing power is increasing? People see that if they hold on to their money, its value will grow and it will buy them more in the future, so instead of spending, they save. The reason an amount of, say, $1,000 will buy them more, is that the value of the goods on the market decreases, including the value of their home and their car and, perhaps most important, the value of their investment portfolio and their retirement savings. They then feel less and less wealthy and become depressed. Many consumers took out a mortgage on their home assuming that it would have a certain value. However, in a period of deflation, home values often fall below the amount of the mortgage, resulting in a big headache for homeowners. Many are now in financial difficulty, which is one of the main causes of the present crisis. So it is easy to understand why we must avoid a prolonged period of deflation.
In times of deflation, contrary to what happens in periods of inflation, businesses are hesitant to make capital investments to manufacture and build inventories of goods whose cost of production may be higher than the final value of the goods produced. But when businesses cut back production, their profits suffer, so they have to lay off workers. And when job losses mount, aggregate demand for consumer products drops. So, total production must be reduced even more until a balance is achieved between supply and demand. In a deflationary period, there is a downward spiral of demand and production. That’s why central banks try to maintain a positive level of inflation, albeit not too high, so that demand and production will rise slowly but steadily. Generally, they aim for an inflation rate of between 2% and 3%.