There are maybe reasons for deflation. So, famous economist Milton Friedman claimed that if the central bank aims for a deflation rate equal to the real interest rate on government bonds, the nominal interest rate should be zero. This would mean that prices would gradually decrease at the real interest rate. His ideas led to the creation of the Friedman rule, a guideline for monetary policy.
Falling prices can happen for various reasons, such as a drop in overall demand for goods and services and higher productivity. When overall demand decreases, prices usually go down too. This change can be due to less government spending, problems in the stock market, people wanting to save more money, and stricter monetary policies like higher interest rates.
Prices can drop naturally when the economy produces more than the amount of money and credit available. This often happens when technology improves productivity, especially in certain goods and industries. As companies become more efficient due to technology, their production costs decrease, allowing them to pass on savings to consumers through lower prices. This is different from general price deflation, which refers to a widespread drop in prices and an increase in the value of money.
Price drops due to higher productivity vary across different industries. Take the technology sector as an example. Over the past few decades, advancements in technology have led to a major decrease in the average cost of one gigabyte of data. In 1980, it cost $437,500 for a gigabyte, but by 2014, that cost had plummeted to just three cents. This sharp decline also led to lower prices for products that rely on this technology.
Shifting Perspectives on the Effects of Deflation
After the Great Depression, when there was a drop in money value along with high job loss and more people unable to pay debts, many economists thought deflation was bad. As a result, most central banks changed their policies to ensure a steady rise in the money supply, even if it led to ongoing price increases and encouraged people to take on too much debt.
British economist John Maynard Keynes warned that deflation can worsen economic downturns. He thought that when asset prices drop, owners become less willing to invest, which leads to more pessimism in the economy during recessions.
Economist Irving Fisher created a theory about economic downturns focused on debt deflation. He believed that when debts are paid off after a bad economic event, it can cause a big drop in the amount of credit available. This drop can lead to deflation, which makes it harder for borrowers, causing more debt payoffs and pushing the economy further into a depression.
Modern economists question traditional views on deflation. There are various opinions about the impact of deflation and falling prices, including a 2004 study by Andrew Atkeson and Patrick Kehoe. They examined 17 countries over 180 years and discovered that 65 out of 73 times deflation occurred, there was no economic decline, while 21 out of 29 depressions did not involve deflation.
Who Gets Affected by Deflation?
People who owe money suffer a lot during deflation. While prices for things go down, the amount they owe stays the same. This affects not just individuals but also entire economies, especially countries with large national debts.
How Can You Escape Deflation?
Governments and central banks, such as the Federal Reserve, have several tools to combat deflation, mainly through expansionary policies. These tools can involve lowering bank reserve requirements, purchasing treasury bonds, and reducing target interest rates. Additionally, fiscal measures like increasing government spending and cutting tax rates can encourage more spending by people and businesses.
Conclusion
Here is the end of Reasons for Deflation. Deflation is when the prices of things we buy, like goods and services, decrease, making money worth more. This can occur for various reasons, such as having less money in circulation or advancements in technology and productivity. Historically, economists thought deflation was a bad thing, but views have shifted. The Pigou effect indicates that falling prices can actually increase jobs and wealth, which can help the economy become more stable.