Question

Deflation refers to the phenomenon of a negative inflation rate. (In 2004, the inflation rate was negative in Hong Kong and we say Hong Kong suffered deflation in 2004.) Many people regard deflation as bad. Can you explain why? Is deflation sometimes good (at least for some people)?

Answer 1

Deflation is a situation wherein the aggregated demand or the total demand in any economy for goods and services declines sharply. This reduces the incentive that suppliers have to stay in the market and is widely seen as being bad for the economy.

The details are as follows: -

Why Deflation is bad for the Economy: -

Deflation results in a cycle wherein one thing attracts another. As described above, the aggregate demand for goods and services begins falling sharply. The resultant is that supply side takes a hit and producers start making lesser profits or even loss in business. As a result, the overall employment levels in the economy go down as producers fire some of the staff to curtail their costs and limit business operations.

As unemployment takes place, we are again in the same cycle that people have lesser availability of funds and aggregate demand falls down even further.

Thus, deflation is not a standalone factor and has far reaching outreach to all Macro Economic variables. The Gross domestic product which the value of Final goods produced in a country fall so rapidly that the economy finds it difficult to recover. The current pandemic situation is a prime example of a recession wherein the price levels and aggregate demand and supply are falling and is beyond correction of the market itself. Most economies are seeing active government intervention through reduced taxation and increased investments which is the only way in which deflation can end.

Is Deflation Good for Some?

Deflation is said to be good or lenders to a certain extent. This can be explained as follows. Suppose as a lender, we lent 100$ worth of money at 10% interest rate for a year. The net return for us is 110$. Now if there is deflation in the economy, that 110$ would be able to purchase more goods and service as the prices have decreased what were a year ago thus making our returns even more positive. With 100$ earlier we were only able to purchase 10 goods for an example in 2019. But now with same 100$ we are able to purchase 15 Goods plus added interest would make it possible for us to consumer 20 goods. This makes our returns better to a certain extent.

Please feel free to ask your doubts in the comments section.