Breaking News: India Inflation Rate reported at 0.27% for the week ending March 14, 2009! • This has been the lowest since 1977. • Are we getting into negative space ? • Will it happen next time? • Are we heading for deflation or is it disinflation? • What are these terms and how do they affect us?
Understanding Deflation – By Prof. Simply Simple • Let is first understand deflation and in this bargain we will understand disinflation. • In economics, deflation is a sustained decrease in the general price level of goods and services.
Also… • Deflation occurs when the annual inflation rate falls below zero percent, resulting in an increase in the real value of money — a negative inflation rate. • Inflation reduces the real value of money over time, conversely, deflation increases the real value of money.
Now let’s understand disinflation… • Deflation refers to a sustained reduction in the level of prices below zero percent based on year-on-year inflation. • Disinflation, on the other hand, denotes a slow-down in the inflation rate (i.e. when the inflation decreases, but still remains positive).
But what are the effects of deflation on theeconomy? • Deflation is caused by a fall in the aggregate level of demand. • This means that there is a fall in the going price for goods. • Because the price of goods is falling, consumers have an incentive to delay purchases and consumption until prices fall further, which in turn reduces economic activity even further.
Lack of demand leads to an increase in the idle capacity bringing down the rate of investments leading to unemployment and lower disposable income and hence a further fall in demand and increase in loan defaults. • This is known as the Deflationary Spiral.
So what can one do about it? • An answer to falling aggregate demand is: • Stimulus, either from the central bank, by expanding the money supply • Suitable monetary policies such as lowering of interest rates so that the consumers are encouraged to borrow and spend of goods and services
While a fall in prices may sound like good news to most, economists see this as an ominous sign of a collapse in demand in the economy.
How does one counteract against deflation? • Until the 1930s, it was commonly believed by economists that deflation would cure itself. • As prices decreased, demand would naturally increase and the economic system would correct itself without outside intervention. • This view was challenged in the 1930s during the Great Depression by the economist Keynes who argued that the economic system was not self-correcting with respect to deflation.
What did Keynes say? • According to him, governments and central banks had to take active measures to boost demand through tax cuts or increases in govt. spending. • Today, to counter deflation, the Reserve Bank of India (RBI) can use monetary policy to increase the money supply and deliberately induce price rise. • Rising prices provide an essential lubricant for any sustained recovery because businesses increase profits and this takes some of the depressive pressures off them.
What about India?Are we heading towards deflation? • Not really. There is no cause for alarm. • What we are witnessing is more of disinflation. Prices are not actually falling yet. • Also this is not expected to sustain itself which is a key requirement for deflation.
And remember in India when we refer to deflation we are talking about WPI – Wholesale Price Index and not CPI – Consumer price index which is used as a reference in most economiesRemember the CPI is still at 10%!
Again one needs to bear in mind that our GDP growth engine is still humming along at nearly 6.5%. • For deflation to set it, the GDP growth rate needs to substantially fall as is seen in many western companies.
Our government still has tools in its armory to counter a deflationary situation. With the help of monetary policy, fiscal stimuli, investment in infrastructure projects etc, we are well poised to ward of any immediate threat of deflation.
To Sum Up • What: Deflation is a sustained decrease in the general price level of goods and services. • How: Deflation occurs when the annual inflation rate falls below zero percent and prices continue to fall on a sustained basis • Why: Deflation is caused by a shift in the supply and demand curve for goods and interest, particularly a fall in the aggregate level of demand. • So: As of now the Indian economy remains fairly robust to ward off deflationary forces.
Hope you have now understood the concept of Deflation In case of any query, please e-mail email@example.com