INTERESTING ARTICLE ON DEFLATION PUBLISHED IN TIMES OF INDIA
Going through the Times of India newspaper today I came across the following article. Thought of sharing this with you:
Deflation: Falling prices do more harm than good
Make People Put Off Purchases, Further Reducing Demand
What is deflation?
As the name suggests, it is the opposite of inflation. In other words, deflation refers to a situation in which there is a sustained drop in the general level of prices in an economy. This is different from disinflation, in which the inflation rate is falling. It is possible to have disinflation without deflation since the inflation rate could be falling even when prices are rising. If, for example, prices were rising faster week after week last year and there was a more moderate week-on-week increase in prices in the current year, the inflation rate would fall (disinflation) without prices themselves falling.
What are deflation’s primary causes?
Just as prices rise when the supply of goods and services is unable to keep pace with demand, prices fall when supply outstrips demand.
This could happen in several ways. If supply increased rapidly but demand did not, you would have a situation in which producers would have to cut prices to be able to sell all they produce. Alternately, supply may not be rising, but demand may be falling, leading to the same situation.
Demand can fall because of recessionary conditions, which cause rising unemployment, investment loss and tight credit markets. Central bank’s measures to control inflation can also at times result to the target being overshot and hence end up in deflation.
Aren’t falling prices good?
It may seem to be good news for consumers, but that could be an illusion. That’s because if prices fall on a sustained basis, both producers and consumers develop expectations that things will get cheaper over time. Consumers would tend to postpone purchases that can be put off. That in turn means demand is further reduced. For producers, lower prices raise the fear of reduced profits and reduced demand can mean idle capacity. Producers would, therefore, tend to cut costs to protect margins.
Since wage costs are among the easiest to cut, deflationary situations often lead to wage cuts and job losses, adding to the problem of declining demand. Companies would also be disinclined to invest in adding capacity. You can see how deflation, if it lasts for a considerable length of time, can set in motion a deflationary spiral falling prices leading to reduced demand that in turn drives down prices further and so on.
How can deflation be fought?
The key is in reviving demand. One traditional method is for central banks to cut interest rates to encourage people to borrow and spend. However, if deflationary expectations are really strong, this may not suffice. In Japan in the 1990s, for instance, deflation persisted for an entire decade despite interest rates dropping to zero.
One other method, therefore, is a more direct injection of demand by the government itself increasing its spending or giving fiscal incentives that encourage individuals and companies to spend.
Is India staring at deflation?
Some economists argue that it is not. They see the current situation as one of disinflation rather than deflation. They also point out that unlike in most deflationary situations, India is not seeing growth drop to zero or negative levels.
In fact, even the most pessimistic projections so far are suggesting that the economy will grow at about 5%. Also, consumer price indices still show a moderately high level of inflation. There are, however, other factors that point towards impending deflation. The wholesale price index (WPI) has dropped from 241.7 on September 13, 2008 to 226.7 on March 7 this year, a drop of 6.2% over a little less than six months. Remember, this is a drop in prices, not just in the inflation rate.
The answer to the question, therefore, hinges on two things. One is how long must the drop in prices continue to be considered sustained.
Second, will the measures taken by the RBI and the government see demand getting revived soon and lead to a reversal of the trend of falling prices? We will know the answer in the coming weeks, but most would agree that even if we do go through a period of deflation, it is very unlikely to lead to the kind of spiral that ends up in a recession.
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