Is Deflation Good or Bad
Deflation refers to an overall reduction in price levels and is associated with lower levels of investment and business, government, and consumer spending. Other reasons are high rates and overvalued exchange rates, deleveraged debt, tight monetary regulations, and reduction in money supply.
Why Is Everybody Afraid of Deflation?
Some finance experts argue that deflation slows down economic growth and is associated with an overall reduction is asset prices and corporate earnings. They also warn that negative inflation affects the operation of financial markets. Many businesses are afraid of deflation because it signals a general fall in demand. At the same time, negative inflation lowers production costs, which is beneficial for businesses. Some experts also emphasize the fact that there is bad and good deflation. Mild negative inflation can be a sign of a healthy economy. It is usually associated with positive supply shocks. Bad deflation, on the other hand, is associated with lower corporate earnings, spending, and payroll. The problem is not deflation per se but inadequate money supply. Negative inflation is not a concern when there is a trend toward a strong investment demand. The same holds when there is a high demand for industrial equipment, machinery, plants, and residential housing. Banks offer secured financing to potential buyers and can seize the collateral in case of default. Low unemployment rates and rising productivity levels are also good signs. This means that employees see their paychecks growing. Then there is a little cause for protests, strikes, and labor unrest.
Can Deflation be Prevented?
Some finance experts claim that deflation can be prevented through instruments of monetary and fiscal policy. Cash-financed transfer payments and tax cuts are two methods to stimulate demand and consumer spending. There are effective unconventional approaches such as VAT reduction, temporary tax changes, negative nominal rates, and open market purchases of foreign and private securities. These measures aim to boost consumption and specifically demand for domestic output. This can happen when foreign currency prices of imported goods, domestic prices of exports, government and consumer spending, and consumption are stable and constant. Monetary policy is also used to reduce the nominal interest rate and boost investment and demand. Several factors play a role to this end – future and current real rates and future and current nominal rates. Low interest rates boost consumption when more households have debt to repay. When more households are creditors (have interest-bearing accounts or other investments), then the opposite effect is observed. There are some unconventional policies that stimulate demand. One solution for central banks is to buy short-dated and long-dated interest-bearing securities so that all securities are held at the bank. Central banks can by options, real estate, stocks, bonds, domestic securities, and private and public foreign currency assets. Fiscal policies are also used to stimulate consumer spending and aggregate demand. A debt-financed tax cut is one possible measure that helps redistribute resources from individuals who are less likely to consume such as unborn, children, and the young to those who are more likely. This is a way to postpone taxes to boost demand. Another way to prevent deflation is to increase public spending on services and goods. Public spending can be financed in different ways, for example, through future or current taxes. There are other unconventional measures such as applying VAT and other distortionary taxes on consumption. The goal is to stimulate earlier consumption by lowering VAT rates today and raising VAT in a future period. Another measure is to print base money and use it to finance tax cuts. Some finance experts find this measure attractive because it is a way to bypass banks. The measure is especially effective and welcome when the banking sector is unstable. Transferring payments to recipients is another measure but central banks are not permitted to implement such measures. In essence, this would mean transferring money to consumers in the hope of stimulating spending. One option for the government is to issue new securities. The central bank will then buy government securities in the secondary market.
Is the Danger of Deflation Real?
Some economists warn that it will be more difficult to offset deflationary pressures in the near future. They suggest that the key to offsetting deflation is adopting radical monetary policies, combined with unconventional approaches. The issue is whether the proposed measures will have a short-term or long-term impact.
Deflation is a concern after a period of economic slowdown in an economy facing low consumer spending and a high unemployment rate. When prices begin to fall, this is a sign of deflation. Businesses and individuals are weary of investing and focus on safe investment instruments such as stocks of established companies, certificates of deposit, and notes and bonds. Some choose to build a diversified portfolio as an added layer of protection. One problem with deflation is that it becomes more expensive to borrow. Thus many consumers fall deep into debt. In a deflationary environment, the money borrowed is worth less than what customers will pay later.
Preventing deflation poses some unique challenges and difficulties but there are conventional and unconventional methods that can be effectively used by governments. Monetary policy is one tool to cure or fight deflation. A combination of fiscal and monetary policies can also prove effective. Monetization of index-linked, nominal, long, and short public debt is one possible solution. Open market purchases of domestic and foreign securities are also used to stimulate demand and cure deflation. Unconventional approaches and policies are also used, for example, negative nominal rates. The policies used largely depend on deflationary pressures and the state of the banking sector. If the banking sector is in a precarious state, then unconventional approaches may prove effective. The solution may be to make structural changes in the banking sector to combat deflationary pressures. Other possible solutions are to increase public spending and cut taxes to boost aggregate demand. Fiscal and monetary stimuli are used to this end.
- Monetary Policy: http://www.centralbanksguide.com/monetary+policy/
- Central Banks: https://www.bis.org/cbanks.htm
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