Deflation Effects on Business and Economy (What are the Main Causes of Deflation?)

Overview

Deflation is the systematic decrease in the prices of goods and services. It is also termed negative inflation. It also refers to the increasing purchasing power of the currency.

Deflation can affect an economy severely. It can slow down economic growth, push unemployment, lead to an economic recession, and affect consumer spending adversely. Central banks take corrective measures such as adjusting interest rates and controlling the demand-supply lines.

Deflation can be good for an economy in some cases. As with inflation, only controlled deflation and up to a certain level can do good for an economy.

Let us discuss the causes, effects, and control measures of deflation for the economy.

What is Deflation?

Deflation occurs when prices of assets, consumer goods, and services fall consistently. Falling prices mean consumers can buy more with less money. Thus, it increases the purchasing power of a currency.

From the outset, the increased purchasing power of a currency and lower prices seem favorable to consumers. However, deflation can cause negative effects on an economy that will eventually impact consumers on a large scale.

Deflation can be caused due to several reasons. The common types of deflation are debt deflation, money supply deflation, and credit deflation.

Credit deflation and money supply deflation are two common types of deflation. When central banks increase interest rates, it results in less borrowing by businesses and consumers. In turn, it results in less purchasing, and economic activities start freezing. Thus, a lack of credit supply causes deflation in the long run.

The shortage of money circulating in an economy increases the value of the currency. It increases the purchasing power of the currency. The prices of consumer goods and services start falling. Thus, a low supply of money also triggers deflation.

What are the Main Causes of Deflation?

Several factors contribute to deflation in an economy. Broadly, there are two main reasons for deflation; an aggregate fall in demand and an aggregate increase in supply. When the balance between demand and supply is affected, it can cause inflation or deflation in an economy.

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Here are a few causes of deflation.

Shortage of Money

A shortage of money supply causes monetary deflation. It happens when central banks increase interest rates. In turn, the borrowing capacity of consumers and businesses decreases. Eventually, there is a shortage of money supply in the economy.

Negative Economic Signals

We can relate negative economic signals to bigger events at the macroeconomic level. For instance, a change in the interest rate can be seen as a negative trigger for the economy. Similarly, when currency exchange rates change or the monetary policy changes of a country, it can give negative signals to an economy.

Such events at the macroeconomic level also start deflation.

Lower Production Costs

Lower production costs mean excessive production. That results in an increased supply of consumer products. The demand falls that cause deflation.

Businesses get affected directly in such cases as they further drop prices to attract customers.

Advancement in Technology

Production can increase due to advancements in technology as well. Better equipment and efficient production processes mean better production. If such an increase in production is greater than demand, it will result in deflation.

Macroeconomic factors such as currency exchange rates, interest rate changes, and a change in monetary policy can also trigger deflation (or inflation).

How Does Deflation Affect Businesses?

Businesses also get affected by deflation negatively. When consumers can buy more with less, businesses need to lower the prices further. Businesses lowering prices further to attract investors results in lower sales. Eventually, businesses start feeling the impacts of deflation through lower sales and falling revenues.

Let us discuss some key effects of deflation on businesses.

Increased Debt Value

Deflation causes increased interest rates. Hence, consumers and businesses face the consequences in the form of increased debt value in real terms. Even if a business can afford to pay more due to the increased power of the currency, the value of debt increases in nominal terms.

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Credit Availability

Since central banks start increasing interest rates to counter deflation, credit availability becomes difficult for businesses. Also, businesses find it difficult to refinance their borrowings.

Decreased Business Revenue

If the deflation continuous for a longer period with high rates, people stop spending. It means lower business sales and revenue for businesses. Thus, even the lower prices of goods do not attract consumers to buy more.

Staff Lay Off or Low Wages

When consumers stop spending due to a shortage of money, businesses face reduced sales. That, in turn, compels businesses to take corrective measures such as lowering staff wages or even in a staff lay-off.

Stagnant Business Growth

Lower sales, reduced revenues, shrinking profits, and staff lay-offs are all consequences of deflation for a business. Eventually, deflation causes stagnant business growth at a large scale in an economy.

Can Deflation have Positive Effects on a Business?

Deflation causes more negative effects on an economy than positives. It means consumers and businesses face negative impacts of deflation. However, in some cases, deflation can provide some relief to consumers and subsequently to businesses.

Improved Technology means Better Profits

Since improved technology and increased production are some of the main causes of deflation, it can be good for a business. A business will eventually benefit from advanced technology and improved profits in the long run.

Innovative Products

Advanced technology and better skills lead to innovative products. Businesses also need to stay innovative to win the competition. Instead of lowering prices, businesses can become innovative in production to attract businesses.

Increased Business Competition

When consumers stop buying, sales fall for businesses. It means business competition becomes stern. It leads to efficient operations and increased productivity for a business. Thus, deflation pushes a business to better performance.

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Lowered Interest Rates

Central banks increase interest rates to counter inflation. That results in deflation if interest rates keep higher for a long time. In deflation, central banks will lower interest rates. In some cases, as low as zero or even negative interest rates.

Control Measures against Deflation

Deflation is a macroeconomic phenomenon. Central banks take drastic measures to counter deflation and control the negative effects on an economy.

Utilize Cash and Cash Equivalents

Businesses need to maintain a sufficient level of liquidity. However, in deflation periods, cash reserves can erode quickly. Safeguarding your cash reserves should be your top priority in a deflation environment.

Invest in Fixed-Income Bonds

When central banks lower interest rates to zero or negative rates, there is no use in keeping your business cash reserves in bank accounts. You can choose to invest in fixed-income bonds that offer better interest rates than bank accounts.

Improve Business Technology

Lower product prices mean you can take advantage of deflation as well. You can buy or lease better equipment to improve your business operation during deflation periods. However, it would help if you stayed cautious of spending useful cash reserves at this stage.

Tax Cuts

One of the corrective measures a government takes to fight deflation is tax cuts. A tax cut can be bad for the government revenue but good for a business.

Lowering Interest Rates

Lowering interest rates can mean a lower return on investments. However, it also means lower costs of borrowings. You can borrow at lower interest rates during deflation periods.

Final Thoughts

Deflation can cause more damages to an economy than inflation. Businesses can get affected quickly due to deflation. Protecting a business against deflation can be difficult as it’s a macroeconomic phenomenon. However, businesses can take advantage of a low deflation environment by taking proactive measures.

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