Economic deflation is a term that refers to a decrease in economic activity in general or stagnation and slowdown in economic movement as price levels fall and growth rates decline.
It is usually defined as a decline in GDP (Gross domestic product; a country's economic output) for a given period, with the level of demand being much lower than supply.
This situation is one of the stages of the economic cycle that comes after the growth stage, but the length of its duration is the most important thing that worries decision-makers.
When an economic downturn occurs, it may result in negative repercussions on the economy in general, such as an increase in unemployment rates, a decline in economic growth rates, and a decrease in economic production and spending.
Historical development of the concept of deflation
Economists in the past did not know the word deflation in the literal sense, and it was defined as a period of depression after which the normal situation returned in terms of the balance between supply and demand, until the term deflation actually entered economic terminology. This was at the beginning of the 19th century; when inflation entered the economic terminology, the word deflation has come to mean the removal of inflation.
The concept of deflation has been closely linked to the concept of inflation, but it is a one-sided connection. Deflation is considered a treatment for inflation, while you cannot treat deflation with inflation, but rather the solution is to restore balance.
How do we know there is deflation?
Economic contraction can be inferred through 3 basic indicators in any economy:
1-Prices fall
2- Increase in the number of unemployed
3-An increase in the balance of payments
Causes of economic deflation
There are many reasons that can lead to an economic deflation and a decline in production
Whether these reasons are alone or combined
1- Decline in external demand for local products (decline in exports)
2- Decrease in the number of tourists
3- Decrease in remittances from workers residing abroad
4- An increase in the prices of imported primary and energy commodities, such as oil
5- Decrease in investments
6- The occurrence of crises due to the bursting of financial bubbles that arise because of speculation, and the mortgage crisis; for instance, the one which broke out in the United States in 2007.
7- Government austerity in spending in a desire to reduce the budget deficit, as this results in a decline in consumption and investment, thus leading to a decline in demand, followed by a decline in production.
8- The central bank’s adoption of a contractionary monetary policy out of a desire to control prices and confront inflation, which reflects negatively on credit due to the high interest rate and decreasing liquidity.
The effects of deflation on the economy
Deflation leads to disrupting the role of money in economic activity and absorbing the increase in the cash balance, as well as limiting government activity, commercial project activity, the volume of credit, and a lack of spending, whether governmental, investment, or private, and then productive activity decreases, growth rates freeze, and prices return to decline.
Deflation means the availability of a small amount of liquidity that is not proportionate to needs, and therefore this will lead to preferring money as a store of value (savings) over its function as a medium of exchange. Thus, the use of money is disrupted, as individual consumption decreases, families reduce their expenses, the movement of payments decreases, the circulation cycle slows down, and the volume of credit decreases.
There is also no movement of financing, and commercial projects also keep many of their assets in cash or financial form, instead of converting them into new real investments or using them to replace consumed production capacity and thus refrain from increasing spending and expansion.
In deflation, the imbalance is also reflected in the price system in a way that is opposite to inflation, and a decrease in prices occurs, but it occurs in a random, unbalanced manner and varies according to the relative importance of goods and services. There are some goods that achieve significant rates of decline, while other goods whose prices fall to a lesser extent are offset by an imbalance in the rates of exchange between these goods. Goods.
The costs of production factors also change, and the wages of workers and employees decrease, but they are at a greater rate than the decrease in the prices of consumer goods for which demand decreases, so production decreases and growth decreases or does not exist, and thus unemployment worsens.
How is economic deflation treated?
To treat deflation, some measures must be taken to move the economic wheel and push society to invest, thus increasing growth and reviving the economy.
Among these procedures are:-
1- Monetary policy:
- Reducing interest rates: Interest rates can be reduced by the central bank to encourage investment and consumer spending, as with lower interest rates there is an increase in the volume of lending, especially lending that aims to invest and build commercial projects, and thus investors turn more to banks to borrow.
- Quantitative easing: Central banks resort to raising the level of liquidity in society directly by pumping cash into the banking sector with what is called monetary stimulus or quantitative easing.
2- Economic policy
Regarding economic policy, the state reduces tax rates and exempts some of them completely, in order to keep the largest possible amount of money in the hands of members of society for two reasons.
First, reduce financial burdens
Secondly, motivating them to consume or invest
Because increased investment creates new job opportunities and thus reduces the level of unemployment, increases economic mobility and raises economic growth
Increasing consumption would raise demand for goods and thus motivate investors to produce, which ultimately leads to increased growth.
In addition, some tax exemptions are to stimulate investment.
The state is also working to increase its spending on productive public projects, such as building roads, institutions, and public works of social benefit, and this in turn increases economic activity.
In the end, the policy dealing with deflation, whether economic or monetary, aims to raise one thing, which is to raise liquidity. Since liquidity is high, it will stimulate investment and thus raise the level of production and thus economic growth.
What is the difference between economic deflation and recession (depression)?
When an economy experiences deflation at significant rates, it is called a recession or collapse
Depression is the catastrophic situation that the economy reaches after the stage of inflation, if economic and monetary policies fail to address it.
Although there is no approved definition for the term recession or depression, the majority of economic analysts talk about this recession when the real gross domestic product shrinks at a rate of more than 10%.
The impact of economic deflation on currencies
This is what concerns us in all of the above so that we can benefit from it in our trading, as economic deflation leads to monetary instability and a decline in growth rates, as well as the start of decreasing the interest rates, and a decline in investment due to the flight of capitalists and damage to the economy, as we mentioned, and this of course will reflect negatively on the value and price of the currency. Thus, it leads to a sharp decline.
