There are chances of the economy moving into deflation. Here we outlines some implications
The stock markets had a few surprises last week. Here, the inflation rate fell to historic lows. The market participants were now foreseeing a possibility of inflation hitting zero. It just showed how times had changed in a short span of a few months.
Just a while ago, investors were praying for lower inflation numbers every Thursday. But the consistent decline in the inflation numbers has left them pondering whether they got more than what they had bargained for, as India may experience negative inflation WoW soon.
What is deflation?
A temporary dip into the negative side will not be immediately considered as deflation. Deflation should not be confused with a temporary fall in prices. It is a sustained fall in prices that occurs when the inflation rate passes down below zero percent. In a deflationary environment, the price of goods and services keep falling. Hence, consumers have an incentive to delay purchases and consumption until prices fall further. This in turn reduces the overall economic activity.
There is a fall in the quantum of goods and services the whole economy is willing to buy, and the price they are willing to pay for goods and services. Since this idles capacity, investments also fall, leading to further reductions in aggregate demand. Deflation also has the side effect of increased unemployment since there is a lower level of demand in the economy. A lower employment level further slows down the demand, thereby contributing to the deflationary spiral.
The appearance of deflation as a widespread global phenomenon is indeed disturbing, not only because of its immediate economic implications, but because until recently most economists regarded sustained deflation as a fundamentally implausible prospect.
Deflation increases purchasing power
Deflation increases the real value of money. It benefits savers and of holders of liquid assets and currency as the real value of liquid assets and currencies keeps increasing as time lapses. On the other hand, it erodes the wealth of investors who have invested in illiquid assets, and borrowers as the value of money invested in an illiquid asset today will be worth less as time goes by.
It also amplifies the quantum of borrowings and is a significant disincentive to borrowers. The payments one is making in the service of a debt represent a larger amount of purchasing power than they did when the debt was first incurred. Deflation is generally regarded negatively, as it causes a transfer of wealth from borrowers and holders of illiquid assets, to the benefit of savers and of holders of liquid assets and currency. It increases the purchasing power of money as time goes by. However, it can cause hardship when the majority of one's net worth is held in illiquid assets.
Way out of deflation
Deflation, at least in theory, is easy to prevent. The government has to just print more money. Printing money is normally a pleasant experience for all governments. Printing more money increases the quantum of money in circulation making it easy for people to spend.
Another measure to counter deflation is monetary policy operations by the central bank. By buying government bonds they increase the money supply and deliberately induce rising prices, causing inflation. Rising prices provide an essential lubricant for any sustained recovery because it increases profits and takes some of the depressive pressures off wages and debtors of every kind.
Impact on investor
Hence, there could be more rate cuts and monetary easing from the Reserve Bank of India. The markets are factoring in a rate cut of 100 basis percentage points. Monetary easing could also take the form of buying government bonds in open market operations.
For individual investors, it also implies that the days of high deposit rates of 10-12 percent are a thing of the past and they will get lower returns on their deposits and fixed instruments. Individual investors who have invested in fixed deposits and bonds will find the intrinsic value of the instruments will increase during deflationary periods.
The stock markets had a few surprises last week. Here, the inflation rate fell to historic lows. The market participants were now foreseeing a possibility of inflation hitting zero. It just showed how times had changed in a short span of a few months.
Just a while ago, investors were praying for lower inflation numbers every Thursday. But the consistent decline in the inflation numbers has left them pondering whether they got more than what they had bargained for, as India may experience negative inflation WoW soon.
What is deflation?
A temporary dip into the negative side will not be immediately considered as deflation. Deflation should not be confused with a temporary fall in prices. It is a sustained fall in prices that occurs when the inflation rate passes down below zero percent. In a deflationary environment, the price of goods and services keep falling. Hence, consumers have an incentive to delay purchases and consumption until prices fall further. This in turn reduces the overall economic activity.
There is a fall in the quantum of goods and services the whole economy is willing to buy, and the price they are willing to pay for goods and services. Since this idles capacity, investments also fall, leading to further reductions in aggregate demand. Deflation also has the side effect of increased unemployment since there is a lower level of demand in the economy. A lower employment level further slows down the demand, thereby contributing to the deflationary spiral.
The appearance of deflation as a widespread global phenomenon is indeed disturbing, not only because of its immediate economic implications, but because until recently most economists regarded sustained deflation as a fundamentally implausible prospect.
Deflation increases purchasing power
Deflation increases the real value of money. It benefits savers and of holders of liquid assets and currency as the real value of liquid assets and currencies keeps increasing as time lapses. On the other hand, it erodes the wealth of investors who have invested in illiquid assets, and borrowers as the value of money invested in an illiquid asset today will be worth less as time goes by.
It also amplifies the quantum of borrowings and is a significant disincentive to borrowers. The payments one is making in the service of a debt represent a larger amount of purchasing power than they did when the debt was first incurred. Deflation is generally regarded negatively, as it causes a transfer of wealth from borrowers and holders of illiquid assets, to the benefit of savers and of holders of liquid assets and currency. It increases the purchasing power of money as time goes by. However, it can cause hardship when the majority of one's net worth is held in illiquid assets.
Way out of deflation
Deflation, at least in theory, is easy to prevent. The government has to just print more money. Printing money is normally a pleasant experience for all governments. Printing more money increases the quantum of money in circulation making it easy for people to spend.
Another measure to counter deflation is monetary policy operations by the central bank. By buying government bonds they increase the money supply and deliberately induce rising prices, causing inflation. Rising prices provide an essential lubricant for any sustained recovery because it increases profits and takes some of the depressive pressures off wages and debtors of every kind.
Impact on investor
Hence, there could be more rate cuts and monetary easing from the Reserve Bank of India. The markets are factoring in a rate cut of 100 basis percentage points. Monetary easing could also take the form of buying government bonds in open market operations.
For individual investors, it also implies that the days of high deposit rates of 10-12 percent are a thing of the past and they will get lower returns on their deposits and fixed instruments. Individual investors who have invested in fixed deposits and bonds will find the intrinsic value of the instruments will increase during deflationary periods.
