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Economics/Deflation factors.

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Question
Dear Prof Raza

Can you list the factors which contributes to deflation in a growing economic nation?.

Thanks
Prashant

Answer
Dear Prashant,

Thank you for raising an unusual question on a rather tricky and rare economic phenomenon.

1. WHAT DEFLATION IS ABOUT
Deflation, opposite of inflation, means a persistence fall in the general level of prices. This comes to the people in a very dangerous garb. Falling price level, one shot or at very low rate, may not seem harmful. On the face of it, the simple drops may look good. Actually, deflation is much worse than inflation. One good thing: deflation is rather rare.

Deflation is a condition that shows the economy is in very bad shape. There is significant unemployment, difficulty in raising additional capital to expand and develop new technologies, decrease in consumption triggering a downslide in GDP through a negative multiplier effect.
What contributes to deflation in a growing economic nation?

2. HOW DEFLATION IMPACTS A GROWING ECONOMY: THE FACTORS BEHIND DEFLATION  

Truly speaking, if an economy is growing, it is likely to be afflicted with the economic malady, inflation, not deflation. When an economy is growing, supply of goods and services are increasing and the country’s production-possibility curve is being shifted upward and rightward. This has to be sustained by increases in demand. This creates employment. Employment gives a boost to income. Consumption increases, and as a result income further increases, leading to greater demand. The upshot is that supply is on the upgrade. Continued increase in demand causes increases in price or inflation. That, in gist, is the normal scenario of a growing economy.

Now come to the abnormal case if prices are falling, i.e., if deflation sets in. Deflation can be caused by a number of factors, all of which stem from a shift in the supply-demand curve. As we have already mentioned about inflation, in the case of deflation the prices of all goods and services are heavily affected by a change in the supply and demand, not prices of only few goods and services –this is a case of general price level. Thus, as demand drops in relation to supply, prices drop accordingly. This can happen because of certain abnormalities. Here are a few of the contributing factors.

3. CHANGE IN STRUCTURE OF CAPITAL MARKETS

As you might have seen what happens in Mumbai or in Delhi,  when many different companies are selling the same goods or services, they will typically lower their prices as a means to compete. Look at the case of mobile telephone. This is probably the cheapest in India than anywhere else in the world. Some sort of a price war takes place, and the companies segue into imperfect competition rather than remain oligopoly as in Canada or in the U.S. If this is a phenomenon in one or two industries, that does not have any unwholesome impact on the economy as a whole. However, if most of the companies go in such down spiral, things turn out too bad. Often, the capital structure of the economy will change and companies will have easier access to debt and equity markets, which they can use to fund new businesses or improve productivity.

“There are multiple reasons why companies will have an easier time raising capital, such as declining interest rates, changing banking policies, or a change in investors’ aversion to risk. However, after they have utilized this new capital to increase productivity, they are going to have to reduce their prices to reflect the increased supply of products, which can result in deflation.”

4. INCREASED PRODUCTIVITY

When a nation is growing, often there are innovative solutions and new processes. That indeed boosts efficiency and in the final analysis leads to lower prices. These innovations may affect the productivity of certain industries. Taken in a lump, all innovations do exert a profound effect on the entire economy. Look back to the U.S.S.R. of 1991: people were willing to work for very low wages and the companies were able to significantly reduce their operating expenses and bolster productivity. Supply of goods went up with decrease in their cost. There then set in  as American companies outsourced deflation near the end of the 20th century.

5. DECREASE IN CURRENCY SUPPLY

The central bank of a country can reduce currency supply in order that people may afford goods and services. This happened in early twenties century in the United States. When the Federal Reserve was first created, it considerably contracted the money supply, giving rise to a severe case of deflation in 1913. Also, in many economies, spending is often completed on credit. Clearly, when creditors pull the plug on lending money, customers will spend less, forcing sellers to lower their prices to regain sales.

6. AUSTERITY MEASURES

Government spending cuts put a damper on governmental, business, or consumer spending. Jobs are few and commodities on shelves are scantier. Sellers have to sell, but buyers cannot afford. Sellers need to coax buyers into buying in order to produce. Prices fall. For example, there was some deflation in Spain and austerity measures in 2010 caused deflation to spiral out of control.

7. DEFLATIONARY SPIRAL

Deflation feeds on itself.  Consumers go on cutting spending because of low income caused by unemployment. This causes business profits to go down. As a result, businesses have to reduce wages and cut their own purchases. This, as a sequel to other businesses and wage-earners having less money to spend, short-circuits spending in other sectors. The cycle, in a vortex of downward spiral, may be difficult to contain.

8. CONCLUSION

I hope, Prashant, this serves your purpose. If you have further question to this rather uncommon economic phenomenon, please do not hesitate to ask. I wish you best of luck in your research endeavor.  

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Eklimur Raza

Expertise

It appears some students in this website are confused about elasticity of demand and the slope of the demand curve when they are trying to figure out why rectangular hyperbola comes up in case of unitary demand curve. First, they don't know that RH can be depicted in a positive quadrant of price,quantity plane. Secondly, they make the mistake that the slope of RH is constant at -1. Two points could help them: first, e=1 at each and every point of the RH, because the tangent at any point shows lower segment=upper segment (another geometric definition of e); yet slopes at different points,dQ/dP, are different; second, e is not slope but [(Slope)(P/Q)]in absolute terms. Caveat: only if we measure (log P) along the horizontal axis and (log Q) up the vertical axis, can we then say slope equals elasticity --in which case RH on P,Q plane is transformed into a straight-line demand curve [with slope= -tan 45 deg] on (log Q),(logP) plane, and e= -d(log Q)/d(log P). [By the way, logs are not used in college textbooks --although that is helpful in econometric estimation of elasticity viewed as an exponent of P, when demand equation is transformed into log-linear form.] I have not found the geometrical explanation I have given in any textbook followed in undergraduate and college classes in Canada (including the book followed in a university where I taught for a short time and in the book followed in George Brown College, Toronto, where I teach.

Experience

About 11 years' teaching economics and business studies, and also English, history and elementary French.Practical experience in a development bank, working with international donor agencies like the World Bank and the ADB. Experience in free-lance journalism, including Canada's "National Post."

Organizations
I teach micro- and macroeconomics at George Brown College (continuing education), Toronto, ON, Canada.

Publications
Many articles and editorials, on different subjects, in English newspapers. Recently an applied Major Research Paper, based on a synthesis of the Solow growth model and the Lewis two-sector model, has be accepted by Ryerson University, Toronto. Professors Thomas Barbiero and Eric Cam, Ryerson University, accepted the paper.

Education/Credentials
Master degree in Interantional Economics and Finance and diploma with honours in Business Administration from Canada.

Awards and Honors
Received First Prize in an inter-university Literary Contest.

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