How Does the Current and Expected Deflation Affect Your Economic Decisions?

Subject:

How does the current and expected deflation affect
your economic decisions?

In order to discuss about potential influence of actual and expected deflation in Poland as well as related economic decisions of a citizen, it is crucial to present the meaning of deflation related strictly to the existing domestic situation as well as it’s background and the value itself.  

According to the information collected and measured by the Central Statistical Office, over the last months of year 2014 in Poland we have encountered a negative inflation rate of ca. -0,6% meaning deflation, which is considered as a tendency also for the following year.^[1] This problem directly became a vivid subject of many discussions. If this so called deflation is a good or bad sign? What to expect after? Which could be the possible solutions against further increase of deflation? For whom it might be profitable? So before any analyze of proper economic decisions to be undertaken, we have to describe what the deflation really is, what kind of deflation we have been affected by over last few months and if it is more complex. Only after such an analyze it is possible to provide or even defend any creative opinion on proper economic decisions which, considering available data, can be possibly no different than regular ones, undertaken during regular, stable economic environment with low inflation and existing economic growth.  

Deflation considered by Economists mainly means a decrease in the general price level of goods and services on the market. Deflation is a negative inflation rate so it occurs when the inflation rate falls below 0%. While inflation reduces the real value of money over time, conversely, deflation increases the real value of money described in a national or regional economy’s currency. This simply allows one to buy more goods with the same amount of money over time.^[2] 

Economists generally believe that deflation is a problem in a modern economy. It increases the real value of debt and may aggravate recession and lead to a deflationary spiral. Since reduction in general price level is called deflation, a deflationary spiral is when reductions in price lead to a vicious circle, where a problem exacerbates its own cause^[3]. In other words by such a deflationary spiral we do consider a situation where decreases in price lead to lower production, which in turn leads to lower wages and demand, which leads to further decreases in price and so on. The deflation even if it is a subject of research and various elaborations, still belongs to the barely known areas. The practical knowledge we may have is based mainly on experience of the Great Recession that took place in years preceding the Second World War as well as actual experience from Japan. From such the perspective we can see that the costs caused by deflation are larger than these generated by inflation. Even though above facts are true, such a situation might be far away from the mentioned occurrence of deflationary spiral. Not every decrease of general price level affects in the same negative way to economy. The negative direction of general price level may not be accompanied by recession or at least considerable reduction of  economic growth. On the other hand the level of costs of deflation depends on its real rate, lasting time but mainly on its origins. Considering all that was above presented, we can describe two main types of deflation:

• Good deflation, where there is no reduction on production and employment. It exists when the reduction rate is not high and the lasting period is not a long one. It may be caused by positive supply shock coming for example from increase of productivity of enterprises or reduction on prices of imported resources. In such case we have the consequences for economic activity which are similar to the situation of low inflation. Since we have no recession affecting the economic environment, there is a tendency toward deflation disappearance.    
• Bad deflation, this is the type that creates large costs as reduction of production and employment rate. In case of bad deflation occurrence we have high price reduction level and long lasting time of such a situation. It is caused by negative shock in demand or sudden break of speculative bubble. Such type of deflation may also be related to low nominal interest rates and possible liquidity trap. Both mentioned situations are very dangerous for economy itself. As for explanation of low nominal interest rates, central banks set them for short-term, which then form the basis for other interest rates charged by banks and financial institutions. Nominal interest rates may be held at artificially low levels in case of major recession to stimulate economic activity^[4]. Approaching or passing zero level of nominal interest rate, central banks may be left without one of most powerful tool to defend the economy. By the liquidity trap we can assume the case which occurs when consumers choose to avoid bonds and keep their funds in savings because of the prevailing belief that interest rates will soon rise^[5].    

There are also two other types called neutral deflation, coming from demand shock and followed by slightly slowing economic activity and the worst one which is ugly deflation. This one is related to the worst case of existing deflation spiral leading to deeper recession and to the economic disaster as the final result.^[6] 

        The fear of deflation that comes from discussions and elaborates is mainly related to its bad or even ugly scenarios, it is clear that it affects mostly conditions from the scope of monetary policy. On one side each related central bank must undertake preventive activities against deflation threat and it must defeat the one if already existing on the other hand. For the government the deflation causes problem of reduced tax and structural income. Even if deflation is related only to a number of segments of goods and services, in the other segments, where inflation exists, there is still existing expectation of lower prices arising. It may lead to the movement toward informal and shadow economy guiding to the lack of budget incomes. In such case government has not so many tools for preventing. The most important problem is a lack of the main tool used during inflation which is the mentioned interest rate itself. As presented above, it is a problem to reduce interest rates below zero, possible but hard regarding cost of cash handling. Further there are additional options of implementation of extra expenses related to tax payment in cash for example, leading to a need of use of banking sector. Deflation causes considerable increase of real interest on public debt while it is no longer allowed to spend the borrowed money and stimulate economy from the demand side. Not like during inflation period when central banks are earning on money emission, during deflation the amount of needed money is reduced so bank cannot print it without adequate coverage. The existing banknotes are rising in a value and the entity responsible for such emission is suffering loss.