Deflation in the Economy

In managing inflation, central bankers attempt to maintain a regime of relatively steady price increases in the general economy in order to encourage consumers and businesses to continue to spend money for goods and services. The rationale at a general level is that products bought today will be more expensive in nominal terms one year from today than they are today. The rationale for time-payment purchases is that a purchaser will repay a loan to finance a purchase in future dollars that are worth less than the dollars used to make a purchase today. Thus, central bankers focusing on the control of inflation attempt to manage the economy in such a way that mild inflation motivates spending without allowing runaway price inflation to destabilize the general economy (Bernanke 3-4).

In contrast to inflation, deflation in an economy inhibits not only economic growth but also inhibits the maintenance of a steady state in an economy. Bernanke (2) defines deflation as a general decline in price levels, as opposed to price level declines in specific industries or sectors of an economy. The primary cause of deflation is a collapse of aggregate demand that extends for a period sufficient to cause producers to reduce prices in order to attract buyers. A deflationary state in an economy, thus, leads to economic recession, increased unemployment, and increased bankruptcies. The inability of businesses to repay major loans, in turn, leads to increased pressures on the financial system with the potential for a collapse of the banking system, as the ongoing deflationary situation in Japan attests (Cargill 114).

To address the problem of deflation directly, there is a need to stimulate consumption. If the interest rate mechanism is not longer feasible to provide such stimulation, Bernanke )6-8) contends that the Federal Reserve should inject money into the economy by (a) expanding the scale of financial asset purchases from asset holders, (b) expanding the scope of financial assets purchased by the Federal Reserve, (c) placing explicit interest rate ceilings on near-term (up to two year maturities) federal securities that would be enforced by Federal Reserve repurchasing activities, and (d) purchasing long-term securities, such as mortgage-backed instruments, to influence effective interest rates on long-term securities. Bernanke (9-10) also suggested that the Federal Reserve could intervene in currency exchange markets to increase the value of the dollar as a means of stimulating demand.

Whereas mild inflation motivates consumption because nominal prices for a product will be higher a year from now than they are today, the reverse is true in a deflationary scenario.

 

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