| | As for "deflation," there are two senses in which that term is used -- (1) price deflation or a fall in the average level of prices, and (2) monetary deflation or a fall in the quantity of money and volume of spending. This distinction parallels a similar one for "inflation" -- price inflation or a rise in the average level of prices, and monetary inflation or a rise in the quantity of money and volume of spending. It is important to keep these two meanings separate and distinct. Failure to do so can confuse economic reasoning.
The old classical definition of "inflation" and "deflation" is the monetary one -- an inflation and deflation of the money supply. The dire consequences of the Great Depression have been blamed on "deflation" without making a careful distinction between the two senses of that term. The real harm of "deflation" during the Great Depression was due to monetary deflation. It was due to a credit contraction and the wiping out of people's savings and assets. It was NOT due to a fall in the average level of prices.
In fact, a failure to let prices (and wages) fall hampered the recovery. Prices and wages were prevented from falling by Hoover's and Roosevelt's misguided economic policies. Prices did fall some but not enough so people could afford to resume buying goods and services to any significant extent. As a result, unemployment was unnecessarily prolonged, because the higher wages prevented employers from creating jobs. Far from being an economic liability, price deflation is an antidote to monetary deflation.
It should be noted that price deflation can occur from an increase in the supply of goods and services relative to an existing quantity of money, just as well as from a fall in the quantity of money relative to an existing supply of goods and services. If the price deflation is due to an increase in the supply of goods and services, it is clearly an insignia of a rising standard of living and should be welcomed on that account alone. A common objection to it especially from mainstream economists is that the falling prices will cause a drop in spending, as people wait for prices to fall further, and that this is bad for business and the economy. These economists will therefore recommend a stable level of prices and argue that the Fed is necessary to regulate the money supply in order to achieve it.
What their objection overlooks is that an economy in which prices are falling due to an increased supply of goods and services is one in which there is less need to save money for the future, because the anticipated lower prices mean greater future purchasing power. So, the tendency to postpone purchases in order to take advantage of the lower prices is offset by the reduced need to save money in order to afford to buy these goods and services. The result is that in such an economy, there is likely to be little, if any, reduction in aggregate spending due to the anticipated fall in prices.
What about a situation in which price deflation is due not to an increased supply of goods and services but to a fall in the quantity of money resulting from the wiping out of people's savings and assets? In that case, won't people postpone spending as they await lower prices in the future? To a certain extent, they will, but if prices are not allowed to fall, they'll abstain from spending to an even greater degree, because they won't be able to afford it. So, even in that case, price deflation is a good thing, because it makes goods and services more affordable.
All in all, there is absolutely no downside to price deflation, and every reason for economists to welcome and promote it. Monetary deflation, on the other hand, is not desirable, but that kind of deflation is due to the Fed's manipulation of the money supply. It is a consequence of the business cycle and of having to rein in monetary inflation.
P.S. I've cross posted this to the Economics Forum under the title: "Deflation unmasked."
(Edited by William Dwyer on 11/14, 2:34pm)
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