Oran A. Hall | If prices only declined
There is good reason why people love when the prices of goods and services fall; they are able to acquire more with the same nominal amount of money.
But, is that all to it?
The fall in the general level of prices in the economy is called deflation. It is the opposite of inflation. It is also different from disinflation, which is marked by prices increasing but at a lower rate than in previous years – three per cent in year two as opposed to four per cent in year one, for example.
Although deflation can be beneficial, it can also be harmful to consumers, businesses and governments and, if not corrected in good time, can inflict serious long-term harm on the economy – and on people and businesses.
Deflation may come about because of a serious and sustained fall in aggregate demand or, on the other hand, an increase in aggregate supply.
Aggregate demand (total demand for consumer goods and services and capital goods) may decline because of the contraction of money supply – the total amount of money available in an economy at a given point in time.
The central bank – the Bank of Jamaica in our case – brings this about by using various tools to cause interest rates to increase. Higher interest rates make it more attractive for consumers to save, and more costly to borrow to spend. Lower borrowing generally leads to lower demand, and the resulting lower sales may lead to lower prices as businesses try to protect their market share.
This can be made worse when producers have to pay more for loans, thereby increasing the cost of operating their business. A scenario such as this generally leads to profits declining.
The best way to prevent this situation from occurring is for the decline in money supply and credit to be matched by a corresponding decline in economic output. Thus, the situation of demand being less than supply can be avoided.
Aggregate demand can also fall when governments reduce spending, be it on infrastructure, salaries, or welfare, for example, because it reduces the amount of money consumers have to spend.
Poor investment outcomes on a wide basis can seriously affect the demand for goods and services. For example, a serious decline in the stock market or the real estate market can affect the ability of people to spend if they suffer significant losses.
Adverse developments in the economy can give rise to uncertainty and cause a loss of confidence in the future of the economy. The resulting concerns about the security of employment may cause consumers to reduce their level of spending.
On the other hand, if the drop in the cost of the factors of production (land, labour, capital) leads to levels of output that exceed aggregate demand, the natural result is for prices to fall, thus impairing the profitability of businesses.
Although consumers have the benefit of enhanced purchasing power in a deflationary environment because the same nominal sum of money is worth more in real terms as it can buy more, they are at a disadvantage in terms of borrowed money they are repaying. This is so because each dollar they repay in the future has more real value than the dollar they repaid in the previous period. Therefore, debt becomes more expensive.
Consumers also benefit from saving, as the money that they do not spend will have more real value in the future, as what it can buy then will be greater than what it can buy now.
In terms of investments, income, such as dividends and interest, as well as principal repayments from bonds, for example, have more value being able to purchase more goods and services as prices fall.
Cash and cash equivalents tend to be attractive options, even if the income they generate is low, because of the tendency for the equities, bond and real estate markets to soften in this environment because of uncertainty and the risk of financial difficulties, even failure,
There are several negative consequences associated with deflation. Falling prices, production and profits often lead businesses to cut costs, one common measure being the laying off of staff. Additionally, high interest rates make debt more expensive and cause consumers to spend less, and this situation can get out of control, even leading to a full-blown recession.
Nevertheless, governments have monetary and fiscal policy tools to spur aggregate demand and get an economy out of deflation.
On the monetary side, the central bank can lower the policy interest rate, ease reserve requirements and buy securities to lower interest rates, thus making it easier to borrow, and to put more money into the hands of the public.
On the fiscal side, governments can increase their spending and reduce tax rates to put more money into the hands of the public. These expansionary initiatives can boost economic activity and change the course of the economy.
A broad-based decline of prices, notwithstanding its benefits, can have serious negative consequences.
It seems, after all, that a healthy, growing economy needs a modest amount of inflation.
Oran A. Hall, author of Understanding Investments and principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel. Email: finviser.jm@gmail.com