Deflation is a phenomenon of persistent and continuous falling prices. In its initial and later stages it maybe respectively referred to as recession and depression. An important difference between inflation and deflation is that in the former, the rate of price rise has no upper limit. It keeps gathering momentum, becomes exponential and finally collapses.
In the case of a deflation, however, prices cannot fall below a certain limit. This is partly because theoretically prices cannot become negative. They also cannot fall to zero. And partly, the downward slide of prices comes to an end because demand refuses to go below a certain level. The consumers, for example, cannot reduce their consumption to zero if they are to live. Similarly, the component of autonomous investment keeps taking place even when due to poor market demand induced investment comes to an end.
Prolonged depressions have been experienced by many economies. The Great Depression of 1930s led to a revolutionary change in economic thought in which Keynesian economics assumed prominence. During this period, it was realized that, comparatively speaking, it was less difficult to check inflation than remedy depression. Availability of credit at low interest rates was insufficient to ensure that .investors would actually borrow and invest. They would do so only if the prospects of earning a profit on new investment were high. Accordingly, the final remedy for a deep deflation was only a direct investment by the public authorities.
Causes and Features:
Deflation is initiated by a situation of excess supply or which is the same thing as ‘deficient demand’. It means that the buyers are not ready to buy the entire supply at the prevailing prices. According to Keynes, such a situation is bound to come into existence, sooner or later, on account of marginal propensity to consume being less than one.
I. However, we may add that, as in the case of inflation, several causal factors can generate this situation, and so-called causes and effects of deflation are always interchanging their roles.
II. With the use of money and operation of market mechanism, prices are constantly under revision. They are all well connected so that fall in any price may initiate the process and deflation starts.
III. Like inflation, deflationary process is also a self-feeding and cumulative one. The rate of decline in prices keeps gathering momentum with the passage of time, till the process exhausts its strength. In other words, deflation is all-engulfing. That is both the speed and coverage of price fall keep increasing.
IV. The inequalities of national income distribution are also deeply affected by ‘ deflation. Residual incomes like profits decrease in both absolute terms and as a proportion of national income. Contractual incomes, on the other hand, get a larger share of national income. However, on account of a rapid reduction in the size of the latter, the absolute share going to even fixed income groups falls.
V. There is also a rapid fall in investment, output and employment.
VI. Rate of interest falls both due to falling prices and easier availability of credit. However, due to a faster decline in marginal efficiency of capital, the rate of investment does no> pick up. Instead, it also falls.
VII. Falling prices generate their own expectations of further price reduction. This induces the wealth holders to shift their asset preferences away from tangible assets and in favor of money and financial assets.
VIII. Propensity to save is encouraged due to falling prices. However, they may not increase in absolute terms due to a fall in output and employment.