Deflation is a situation in which falling prices are accompanied by falling levels of employment, income and output. Deflation may be due to certain natural causes, or it may be due to a deliberate policy of the government. The following are the important causes of deflation.
(1) Keynes’ Explanation:
Keynes had developed a systematic theory to explain the causes of deflation (or depression).
(i) Deficient Aggregate Demand:
The main reason for deflation is the deficiency of aggregate demand which leads to over-production and unemployment. Aggregate demand consists of aggregate consumption expenditure and aggregate investment expenditure.
(ii) Less Investment Expenditure:
Private investment is governed by marginal efficiency of capital (MEC) and rate of interest. Deflation is the result of decline in investment which is due to (a) low MEC or low profitability of capital and (b) high rate of interest.
(iii) Fall in MEC:
As the process of economic expansion goes on, certain forces come into operation which exerts downward pressures on MEC. These forces are:
(a) During the process of expansion costs of production start rising on account of the increasing scarcities of materials and equipment. Wage cost also rises because of scarcity of labour. Rising costs have the depressing effect on MEC.
(b) Increasing abundance of output resulting from industrial expansion leads to lessen the returns below expectations which also depress MEC.
(iv) Less Consumption:
The basic cause of deflation or depression lies in Keynes’ concept of consumption function or his\psychological law of consumption. According to this law, the consumers do not spend the whole of the increment of their incomes on consumer goods.
As the income increases, the community spends a smaller proportion of its increased income on consumer goods.
The reduced sale of consumer goods leads to the accumulation of stock of consumer goods (or overproduction). This also has adverse effect on business expectations and MEC.
(v) Rise in Rate of Interest:
The fall in the MEC is followed by a rise in demand for money or rise in liquidity preference (i.e., the tendency of the people to keep money in cash form). No one likes to purchase goods or securities when the prices are falling.
Given the supply of money, increase in liquidity preference results in the rise in the rate of interest which also reduces investment.
To sum up, according to Keynes, rising rate of interest, declining MEC, falling tendency of consumption all these factors lead to reduce aggregate demand which ultimately result in deflationary conditions in the economy.
(2) Contractionary Monetary Policy:
When the government adopts a contractionary monetary policy, it makes the availability of credit more costly by raising the rate of interest and reducing the supply of money.
This results in fall in prices. Various contractionary monetary measures are: raising the bank rate, sale of government securities, raising the cash reserve ratio, reducing the currency, etc.
(3) Reduction in Government Expenditure:
If the government decides to reduce public expenditure, it will reduce national income and employment multiple times (through the adverse working of multiplier). This will reduce aggregate demand, discourage investment and affect the economic activity of the economy adversely.
(4) Heavy Taxes:
Heavy taxes imposed by the government reduce the disposable income with the people. This leads to the decline in both consumption and investment expenditure and results in deflationary conditions.
(5) Increasing Economic Inequalities:
Increasing inequalities of income and wealth make the rich more rich and the poor more poor. Since the marginal propensity to consume (MPC) of the rich is less than that of the poor, growing inequalities of income will reduce consumption expenditure and will lead to deflationary situation.
(6) Public Borrowing:
When the government borrows from the public, it results in the transfer of money from the public to the government. This reduces aggregate demand and brings deflation in the economy.
(7) Psychological Factors:
Some economists feel that deflation and depression are the result of waves of optimism and pessimism. During the optimistic conditions of boom, they make over- investment.
As a consequence, they fail to find buyers for their products, suffer losses, grow pessimistic about the prospects of business and curtail their productive activities. Thus, the discovery of error of optimism gives birth to the opposite error of pessimism.
(8) Other Factors:
Some other non-economic and non-monetary factors, such as, wars, earth quakes, strikes, crop failures, etc. may also cause deflationary conditions.