- India Inflation Rate reported at 0.27% for the week ending March 14, 2009!
- This had been the lowest since 1977.
- Did we go into negative space ? Yes, it was around – 0.36%.
- Will it happen next time?
- Did we head for deflation or was its disinflation?
- What are these terms and how do they affect us?
- Let us first understand deflation and in this bargain, we will understand disinflation.
- In economics, deflation is a sustained decrease in the general price level of goods and services.
Also…
- Deflation occurs when the annual inflation rate falls below zero percent, resulting in an increase in the real value of money — a negative inflation rate which we saw in 2009.
- Inflation reduces the real value of money over time, conversely, deflation increases the real value of money.
Now let’s understand disinflation…
- Deflation refers to a sustained reduction in the level of prices below zero percent based on year-on-year inflation.
- Disinflation, on the other hand, denotes a slow-down in the inflation rate (i.e. when inflation decreases, but still remains positive).
But what are the effects of deflation on the economy?
- Deflation is caused by a fall in the aggregate level of demand.
- This means that there is a fall in the going price for goods.
- Because the price of goods is falling, consumers have an incentive to delay purchases and consumption until prices fall further, which in turn reduces economic activity even further.
Lack of demand leads to an increase in the idle capacity, bringing down the rate of investments leading to unemployment and lower disposable income and hence a further fall in demand and increase in loan defaults.
This is known as the Deflationary Spiral.
So, what can one do about it?
An answer to falling aggregate demand is:
- Stimulus, either from the Reserve Bank of India, by expanding the money supply.
- Suitable monetary policies such as lowering of interest rates so that the consumers are encouraged to borrow and spend of goods and services.
While a fall in prices may sound like good news to most, economists see this as an ominous sign of a collapse in demand in the economy.
How does one counteract against deflation?
- Until the 1930s, it was commonly believed by economists that deflation would cure itself.
- As prices decreased, demand would naturally increase and the economic system would correct itself without outside intervention.
- This view was challenged in the 1930s during the Great Depression by the economist Keynes who argued that the economic system was not self-correcting with respect to deflation.
What did Keynes say?
- According to him, governments and central banks had to take active measures to boost demand through tax cuts or increases in government spending.
- Today, to counter deflation, the Reserve Bank of India (RBI) can use monetary policy to increase the money supply and deliberately induce price rise.
- Rising prices provide an essential lubricant for any sustained recovery because businesses increase profits and this takes some of the depressive pressures off them.
To Sum Up
What: Deflation is a sustained decrease in the general price level of goods and services.
How: Deflation occurs when the annual inflation rate falls below zero percent and prices continue to fall on a sustained basis.
Why: Deflation is caused by a shift in the supply and demand curve for goods and interest, particularly a fall in the aggregate level of demand.
