Deflation - Is the Threat for Real ?

DEFLATION: IS THE THREAT FOR REAL?

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While the situation of inflation is quite common for the developing economies and most of the people are well versed with problem of inflation and know its implications in general, the situation of deflation is rare. In developing countries, deflation has entirely different connotations than those of the inflation. In the common parlance deflation is an economic situation of falling prices, but in economic theory there is much more to it than just the reducing price level.

In economic terms, deflation can be termed as a situation of declining prices, often caused by a reduction in the supply of money or credit. It can also be caused by the direct contraction in expenditure, including the public expenditure, personal spending or the investment expenditure. This is opposite of inflation and often leads to lower effective demand and increasing unemployment rate in the economy.

According to economic theory, price level is the result of functional relationship between demand and supply. To put it simply, the supply being constant, if the demand of the goods and services increases in an economy, the prices are likely to go up and the economy is likely to encounter a situation of inflation. On the other hand, if the supply increases with demand being constant, or the supply increases more than the demand, the prices may fall and such a situation may be referred to as ‘deflation’.

In addition to the above demand supply dynamics, the inflation or deflation can also be caused by the reasons of the adequacy or lack of money supply in the country. If the money supply is less, it is a situation of more money chasing lesser goods and services, leading to general rise in prices. On the other hand, if the money supply is more than the supply of goods and services, the situation of fall in prices is generally experienced and is referred to as deflation.

Deflation caused by rapid growth of production and manufacturing in the country, causing the supply to go up is good for the economy, as with abundant availability of all goods and services in the economy, the prices go down, resulting in increase in the real income and wealth of all the consumers. Such a situation does not harm the producers also, as they gain by increasing sales volumes.

The Great Depression of 1930s was associated with deflation and it is said that the recession coupled with deflation leads the economies to suffer. It is this very concern which is causing anxiety among the economists and the policy makers. But it must be clearly understood that deflation and depression are two different words and situations and should not be taken as synonymous.

Effects on the Economy

Temporary fall in prices is not deflation and it is the sustained fall for a considerably long period of time which is a matter of serious concern. It causes the aggregate demand to fall, as due to the falling prices the consumers try to delay the purchases, which in turn reduces economic activity in the economy, thereby accentuating the spiral effect of deflation. The result is that the existing manufacturing capacity of the economy becomes idle, leading to further reduction in aggregate demand and even more reduction in economic activity. If the process continues without any interventions from the government, the economies may move in to a situation of recession.

Theoretically speaking, the situation of deflation may also lead to a peculiar economic condition known as the ‘liquidity trap’. Generally, the rate of interest in an economy is linked to the rate of inflation. But the situation of deflation may necessitate the interest rates to go down as low as zero. Deflationary times and zero interest rates reduce the economic viability of most of the projects due to tremendously reduced demand and the investors also tend to postpone their new projects. This worsens the situation further.

Generally, the deflationary situation encourages people to hold on to their money, mainly because of the reasons like lower aggregate demand for newly produced goods and very low interest rates that discourage the people from keeping money in bank deposits. This causes substantial reduction in the velocity of money i.e. reduction in the number of transactions, dramatically reducing the money supply in the economy, as one man’s expenditure is the income of another. Reduced velocity of money results in reduction of incomes.

Deflation results in fall of availability of hard currency per person. This further results in increasing the purchasing power of each unit of currency, as the average price level goes down. Increase in purchasing power may sound beneficial to a layman but actually it may cause hardship to those people whose majority of wealth is kept in non-liquid assets such as real estate, land and buildings.

It is thus evident that sustained deflation is a serious cause of worry to the policy makers, as it may lead the economies to recession and, more seriously, to a situation of depression.

Indian Fears

In India, the rate of inflation or deflation is measured on the basis of Wholesale Price Index (WPI) on weekly basis and then computed for the fiscal years for the purpose of policy monitoring, appraisal and decisions. WPI is an indicative and representative index of the wholesale prices of various commodities produced in the economy. Consumer Price Index (CPI), on the other hand, is an index of the consumer prices that give 46 per cent weightage to the food items, 15 per cent weightage to the domestic facilities, 6.4 per cent to lighting and fuel and 6.6 per cent to apparel and shoes.

The inflation rate in India has suddenly fallen to a level of less than half a per cent and closer to zero in March 2009 onwards and the fears of the Indian economy slipping into a precarious situation of deflation have been expressed by many. But despite extremely lower inflation rate, the prices of food items are still experiencing reasonably higher increase in prices. This, while putting the economically vulnerable sections of society in a disadvantageous position, has also given a glimmer of hope to the policy makers because this phenomenon may gradually stabilize the economy and help it come out of the deflationary pressures early.

The economists are in a fix and do not know whether to call this economic situation in the country as deflation or disinflation. While the deflation is persistent fall in price level, disinflation is a situation where the inflation rate goes down. The economic theory provides separate sets of solutions for both the situations and unless the situation is clearly identified and diagnosed, it would be difficult to resolve it.

Government agencies in India vehemently deny that there is any fear of deflation in the near future. The International Monetary Fund has projected the annual inflation rate of 1.7 per cent for the Indian economy for 2009-10. This implies that for some part of the year, the economy may experience a brief spell of deflation. Whether or not to call such a situation a deflationary situation, is a matter of argument.

As per Mr P.K. Padhy, Economic Advisor in the Ministry of Commerce and Industry, the current economic situation is that of disinflation in India. The basis for such a belief is that the economy has grown at the rate of 5.3 per cent in the third quarter of the previous fiscal. Economists like Suresh Tendulkar and Pranab Sen also argue on the same lines. In one of its reports on the Indian economy, the Citigroup has said that the deflationary patch in India is due to high base effect and supply side issues and is likely to be temporary and short-lived in nature. But persistence of such a situation may increase the problems of the economy in the months to follow.

Many economists believe that the current situation can be termed as ‘demand deflation’. Both production and the prices are falling down. This would require more targeted fiscal measures, along with stepped up direct government purchases and increased scope of public distribution system.

The situation in India may not be as grave as that of sustained deflation. The CPI is still positive and at around 10 per cent; the rural demand for FMCGs is robust and food items are in great demand. The resilience of our economy may not allow the typical deflationary situation to emerge and the current phase may turn out to transient and temporary. Despite the above, the situation needs to be tackled by the Government very carefully.