Something New to Worry About: Deflation

'Inflation' is something that most people understand quite well. Whenever prices rise, the public, the government, the media work themselves into a frenzy. On the other hand, 'Deflation' i.e. a fall in prices is mostly ignored by the public. It might seem hard to understand what the problem is with falling prices. If all they mean is that we can buy stuff for less this month than we could have a month ago, what’s there to worry about?

A lot. If prices persist in their decline, they could be devastating to the economy. To understand the impact of deflation, we have to understand what it really means.

What Is Deflation?
"Deflation" is a contraction in the volume of money and credit relative to available goods.

The most common misunderstanding about inflation and deflation is the idea that inflation is rising prices and deflation is falling prices. General price changes are simply the effects of inflation and deflation.

During a deflationary phase there is a general decline in prices, with emphasis on the word "general". Sector-specific price declines are generally not a problem for the economy as a whole and do not constitute deflation. Deflation occurs only when price declines are so widespread that broad-based indexes of prices, such as the consumer price index, register ongoing declines.

There are four causes of Deflation are:

1. Decreasing Money Supply
2. Increasing Supply of Goods
3. Decreasing Demand for Goods
4. Increasing Demand for Money

Danger Of Deflation

A sustained drop in prices hurts in two ways.

Impact On Consumer Spending
Because consumers and businesses expect that prices will continue to fall, they would be likely to cut back further on spending and investment. As spending dries up, the economy starts to shrink. As GDP shrinks, so do the companies providing those goods and services for consumers. As companies shrink or go out of business, unemployment rises. Out-of-work consumers have less money to spend, which cuts deeper into the economy. Once the cycle takes hold, it's very difficult to stop. A downward "spiral" begins, feeding on pessimism.

Impact On Debt Servicing
Even more debilitating is the impact on on consumers’ ability to service their debts.
Suppose you have a loan of Rs 10000 and you earn Rs 1000/year. There is heavy deflation, prices and salaries fall. Your salary might go down to Rs 900/year, but your loan would remain the same. Suddenly repaying the loan has gotten a lot tougher.

A deadly mix of falling prices and high leverage could foment a “debt-deflation” of the type first described by Irving Fisher, an American economist, in 1933. In this worst-case scenario, banks concerned about their corporate customers’ indebtedness demand debt liquidation, which forces firms to sell off assets at fire-sale prices to pay them back. Money in circulation declines as banks hoard the dollars, which causes spending to drop and prices to fall, depressing businesses’ net worth and profits and throwing many into bankruptcy. Companies cut production; workers are laid off. This deepens pessimism and leads to more hoarding of money.

The current American Federal Reserve chairman, Ben Bernanke made a presentation before The National Economists Club, Washington, D.C.on November 21, 2002. It is a really good document considering that it was written way back in 2002
(You can read the 2002 speech here)