Is deflationary shock good or bad for the economy?

When an economy suffers from a deflationary shock, its impact on consumers and businesses may be positive or negative. There is a big difference between the terms deflation and deflation. Before discussing the causes and effects of deflation shocks and how these shocks affect the economy, consumers, and businesses, we will discuss them first.

See: About inflation
Deflation usually occurs during economic recessions and manifests itself as a slowdown in price increases; this is caused by a decline in consumer sales. If the inflation rate drops to a lower level than before, technically speaking, the difference is deflation.

On the other hand, deflation can be considered the opposite of inflation, or negative inflation, which occurs when the supply of goods or services grows faster than the money supply.

Deflation and its causes Deflation manifests itself as continuous contraction or decline at the same time:

  • The overall price level of goods and services that make up the consumer basket (consumer price index)
  • Commercial and consumer credit availability (credit/loan practices)
  • Consumer demand triggered by a decline in the money supply
  • Government spending
  • Business investment expenditure
  • Investment assets

The precursor or prerequisite of deflation may be a period of economic recession (which may worsen into an economic depression), during which either credit is excessively expanded or large amounts of debt are assumed.

Deflation can be triggered by any combination of the following factors:

  • The money supply drops
  • Increased supply of goods or services worsens the situation and further reduces prices
  • Commodity demand drops
  • Increase in demand for money

An increase in the demand for money or a decrease in the supply will cause people to want more money, leading to higher interest rates (money prices). Rising interest rates will lead to lower demand because consumers and businesses will borrow less to make purchases.

If deflation intensifies, it will plunge the economy into a deflationary vortex. This happens when a price drop leads to a drop in the level of production, which in turn leads to a drop in wages, which in turn leads to a decline in demand from businesses and consumers, which in turn leads to a further drop in prices. The two sectors of the economy that have traditionally been immune to economic downturns are education and health care, because their costs and prices may actually rise, while the overall price level of most goods and services is falling.

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Money supply and deflation Let us look at the factors and components of deflation, how each factor works, and how they affect the economy. We will start with money supply, loans and credit availability.

Money supply is defined as the total amount of money available in the economy at a given time; it includes money and various deposits provided by banks and other depository institutions. Although currency no longer has intrinsic value, it does have four very valuable functions that promote economic and social operations: it acts as a medium of exchange, a unit of account, a store of value, and a deferred payment standard.

Type of Credit
Credit, and the extension of credit, is the debtor’s ability to obtain cash to achieve financial or non-financial goals. There are two different forms of credit, each of which has a different effect and impact on the debtor.

The two types of credit are self-clearing credit and non-self-clearing credit. Self-liquidating credits are usually loans required to produce (capital) goods or provide services, and have a fairly short to medium term. Due to its nature, the use of this type of credit generates financial returns and cash flow, which enables it to repay the loan and add value to the economy. Non-self-liquidating credit is a loan used to purchase consumer goods (consumption); it has nothing to do with the production of goods or services, it relies on other sources of income or cash to repay, and because it does not generate any income or cash to liquidate itself, Therefore, it tends to stay in the system for a long time. This type of loan and credit expansion tends to be counterproductive, adding a lot of cost (including opportunity cost) to the economy instead of value, because it tends to burden production.

Loans are based on a two-fold principle: the willingness of the lender to provide credit and funding to consumers and businesses, and the borrower’s ability to repay the loan at a given interest rate based on the credit score and rating (price)). Both of these principles rely on the trust of lenders and consumers in each other, and a positive production trend that enables debtors to repay their loan obligations. When this upward production trend slows or stops, confidence will also decline, which will affect the willingness to lend and the ability to repay loans.

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This situation shifts the attention of all participants in the economy from growth to protection and survival. This means that creditors have become more conservative and cautious in their loan practices and applications, leading to a decline in consumer and corporate spending; this will subsequently affect production because of the decline in demand for goods and services. The decline in business and consumer spending puts downward pressure on the prices of goods and services and leads to deflation.

The impact of deflation on the economy
What happened during the deflationary shock? People increase their savings and decrease their expenditures, especially when they are afraid of losing their jobs or other sources of income. The stock market experienced severe volatility and showed a downward trend, while company acquisitions, mergers and hostile acquisitions decreased. The government revises or implements increasingly stringent regulatory legislation and implements government structural changes. Because of this behavior, investment strategies will shift to lower risk and more conservative investment tools. In addition, investment strategies will favor tangible investments (real estate, gold/precious metals, collectibles) or short-term investments, which tend to maintain their value and provide consumers with more stable purchasing power.

Macroeconomic perspective
From a macroeconomic point of view, deflation is caused by the shift in the demand (investment and savings equilibrium) and supply (liquidity preference and money supply equilibrium) curves of the final products and services and the decline in aggregate demand (gross domestic product). of. Monetary policy can influence and change.

When the volume of money and credit transactions relative to the volume of available goods and services declines, the relative value of each unit of currency will rise, leading to a decline in commodity prices. In fact, what fluctuates is the value of the currency itself, not the value of the commodity reflected in its price. The price effect of deflation often occurs and affects commodities and investment assets across the board.

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Microeconomic perspective
From a microeconomic perspective, deflation affects two important groups: consumers and businesses.

Impact on consumers
Here are some ways consumers can prepare for deflation:

  • Repay or repay any debts that are not self-liquidating, such as personal loans, credit card loans, etc.
  • Increase the amount of savings for each salary
  • Maintain retirement contributions despite stock market volatility
  • Find bargains and negotiate durable goods that need to be purchased or replaced
  • If you feel unsafe about the continuity and stability of your work or income-generating assets, start looking for other sources of income
  • Return to school or update skills to enhance personal market competitiveness

Impact on business
Here are some ways companies can prepare for deflation:

  • Develop an action plan to provide alternatives to any business aspect, department or cost affected by deflation
  • Carefully plan the production of goods and services and reduce inventory
  • Investment planning should focus on high-value goods or services and avoid high-cost/low-value goods or services
  • Increase investment to increase productivity and reduce costs
  • Reassess all costs and contractual agreements with customers and suppliers, and take appropriate actions when necessary

The bottom line If a manufacturer or supplier can produce more goods at a lower cost, thereby bringing lower prices to consumers, then deflation may be beneficial. This may be due to cost-cutting technologies or improved production efficiency due to technological improvements. Deflation can also be considered beneficial because it can increase the purchasing power of money and thereby purchase more goods and services.

However, deflation can also be harmful to the economy because it forces companies to reduce prices to attract consumers and stimulate demand, which has further harmful effects. Deflation also has a detrimental effect on borrowers because they must repay loans in U.S. dollars, which will buy more goods and services (higher purchasing power) than they borrowed in U.S. dollars. Consumers or companies that obtain new loans will increase the actual or inflation-adjusted cost of credit, which is the opposite of what monetary policy is trying to achieve in response to falling demand. Deflation forces a country’s central bank to reassess its monetary unit and adjust its economic and regulatory policies to respond to deflationary shocks.

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