Friday, March 20, 2009

Now Deflation!!

Inflation, if you remember was the buzzword for most economists and policy makers. Even you as students would have had to bear seminars, presentations, questions and discussions on inflation. Less than a year later, the government seems to be worried about “Deflation”!!

Now wasn’t it the same government who went to lengths trying to reduce inflation? So should they not be happy that inflation figures are diving headlong and fast approaching zero and if some experts are to be believed, will hit negative figures by year end. The same policy makers are now scared of the looming Deflation!

So what is this “Deflation” and why is it so scary?

To understand deflation, let us review inflation first. Inflation you may remember was a term used to signify a general increase in price levels of stuff. Inflation meant that stuff would keep getting more and more expensive and in a way the value of money would decrease as the same one rupee would be able to purchase less. And I am sure you remember the two very basic reasons which can cause inflation: Increased money supply and the resultant increase in demand or a decrease in supply due to various reasons.

Now deflation is a persistent fall in price levels or the commonly followed macroeconomic indicators like in our case it would be the WPI (Wholesale Price Index). Please remember, the decrease in the rate of inflation (the rate at which inflation is growing) is called “Disinflation”. Disinflation and deflation are two very different terms. Generally, a one-time fall in the price level does not constitute a deflation. Instead, one has to see continuously falling prices for well over a year before concluding that the economy suffers from deflation.

In a deflationary environment, as the price of goods fall, people have look to delay purchases in the hope that the prices will fall further and that reduces the demand and therefore overall economic activity. So it is almost like a negative vicious circle where decreasing prices lead to decreasing demand (as people do not buy hoping for further fall in prices) and the decreasing demand leads to further decreasing prices. Ultimately the wealth creation of an economy goes for a six!


Satindra said...

Deflation is an implosion, and to my mind, worse than inflation. You don't know what sucked you in. Everything just shrinks and that is scary.

Gagandeep Rana said...

Studied this topic in the 2nd sem but never thought of being so close to it.
Sir, with your due permission I would like to add something here.

Deflation, if continues for some time, causes the economy to enter a situation called "Liquidity Trap".
In this situation in spite of pumping money into the system, the economy is not able to revive.
This happens because in such a situation the interest rates are so low that consumers prefer saving their money in the bank hoping for the interest rates to rise.

I hope this situation does not worsen even further and our Govt. takes effective measures in keeping a check on it.