Question

Explain two examples for destabilizing effects of deflation. (1)

Answer 1

Deflation represents a decrease in prices of goods and services throughout the economy, it is a situation where inflation increases at a slower rate. It is a rare phenomenon that does not occur in the course of a economic cycle, and therefore, investors must recognize it as a sign that something severely wrong with the state of the economy.

Deflation are caused by several factors such as change in structure of capital markets by lowering interest rate, increased productivity, decreased currency supply, austerity measure i.e decreased governmental, business or consumer spending and deflationary spiral.

Effects of deflation on the economy

1) Reduced business revenues and wage cutbacks and layoffs

Businesses must reduce the prices of their product to stay competitive, but their revenue also drops.Their profit margins eventually drops, as savings from material costs are offset by reduced revenues. When revenues start to drop, companies find ways to reduce their expenses by reducing wages and cutting positions. Understandably, this exacerbates the cycle of inflation, as more would be consumers have less to spend.

2) Reduced stake in Investment and reduced credit

When the economy goes through a series of deflation, investor tend to view cash as one of their best possible investment as they will watch their money grow simply by holding onto it even with decreased interest rate. in the meantime, many other investments may yield a negative or highly volatile, since investors are scared and companies aren't posting profits. As investors pull out of stocks, the stock market inevitably drops.

When deflation starts, the financial lenders quickly start to pull the plug on many of their lending operations for variety of reason. As asset such as houses decline in value, customer can not back their debt with the same collateral. In the event the a borrower is unable make their debt obligations, the lender will be unable to recover their full investment through foreclosures or property seizures.

Historical example of deflation is the Great Depression which was the most financially trying time in American history. During this dark era, unemployment spiked, stock market crashed, and consumer lost much of their savings. Also, employees in high production industries such as farming and mining were producing a great amount, but not getting paid accordingly. As a result they had less money to spend were unable to afford basic commodities, even in spite how much vendors were forced to reduce prices.