Deflation, Causes and Effects

Deflation, Causes and Effects

german deflation

Deflation is defined by the widespread and prolonged decline in the price level of goods and services in an economy. According to the IMF, this drop should occur for at least two semesters in a row. The main cause of this phenomenon corresponds to the drop in demand.

Deflation generates a vicious cycle of falling demand, companies see their benefits reduced by having to cut prices to generate sales. As a result, they have to cut costs, which means that they have to cut employees. In turn, if there are people who become unemployed, the demand will continue to decline as these also will stop buying, and so on.

european country deflation

In addition, experts agree that deflation in an unbalanced economy like the Spanish economy for example, with high debt, is an added problem. If prices fall, GDP is automatically reduced, but not the debt. This results in the rise of debt in relation to the national GDP, increasing the possibility of a default of the State.

Economic policies that can be applied to act against deflation will be aimed at stimulating demand to cover the gap between supply and demand. The consensus among economists on the best option is limited to a priori emphasis on action (to prevent deflation) rather than a posteriori (fight deflation). It is easier to prevent it rather than to fight it.

From there, the views are grouped around two proposals. The first, monetarist, suggesting lower interest rates and funding some financial institutions to encourage lending to households and businesses. The second option is more Keynesian, aims to increase government spending to boost the economy. Normally, the best option will depend on each situation and will consist of a combination of both proposals. Changing some laws to facilitate the situation to the big companies where lots of jobs are in danger.