Question

7. Why is deflation self perpetuating?

8. A large part of a CEO’s compensation is in the form of options that are currently not in the money. How would this change the CEO’s incentives compared to if the compensation was in the form of futures instead? How would the CEO’s incentives change if the options were put options instead of call options?

Answer 1

A deflation refers to a general decline in the price levels of goods and services. It occurs when the inflationary rate is below 0%. It improves the value of the currency as against inflation which reduces the value of a currency. Thus, deflation allows the consumer to purchase more amount of goods and services with the same amount of money. It usually happens in an economy when the supply is high and the demand is low.

                                    A deflation in some cases can be self-perpetuating which means that the outcomes of the deflationary situation may lead to further deflationary effects in the economy which would continue as a spiral and consumes an economy. A deflationary spiral refers to such a situation wherein the decrease int h price levels would lead to lower production, which in turn leads to lower wages and demand which further leads to a decline in the price level in the economy. Her, the reduction in the price levels are expected to create a vicious circle. The great depression of 1930’s is a general example of what a deflationary spiral can be and how it can be self-perpetuating in nature.

                                    When the prices starts to fall, the people would think that it is better to spend the money tomorrow when the prices would become cheaper than spending it today.This leads to lower spending in the economy which would mean that the consumption patterns in the economy are also lower. This process would lead to lower demand in the economy. When the demand becomes lower, according to the law of supply and demand, the production in such an economy would also decline which would decrease the prices of the goods and services further and has the potential to self-perpetuate.