Deflation: Definition, Causes, Effect & Control of Deflation

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What is Deflation?

Deflation refers to a persistent or continuous fall in the general price level. The value of money increases during a deflationary period.


Causes of Deflation

  • Excessive budget surplus: By spending less money than its revenue, the total amount of money in circulation would fall.
  • Excessive supply over demand: If the supply of commodities continues to be in excess of demand, producers would be forced to sell at lower prices.
  • Excessive credit squeeze: Too much restriction on bank lending decreases the amount of money in circulation and reduces aggregate demand, leading to lower prices.
  • Excessive use of government fiscal policy: Very high rates of taxation would reduce aggregate demand considerably since disposable incomes are greatly reduced.

Effect of Deflation

Deflation has a number of effects. They include;

  • A decrease in business earnings and profits: The profit margin of producers would fall because they sell their goods at continuously lower prices.
  • Increased rate of unemployment: Investment is not encouraged, and so the demand for labour and other factors of production decreases thereby, causing unemployment.
  • Fixed income earners gain: Those on fixed income such as pensioners, teachers etc. have an increase in their real income.
  • Lenders gain at the expense of borrowers: Since the value of money increases during a deflationary period, the borrower repays more in real terms.
  • An increase in the burden of the national debt: The burden of national debt is made heavier by deflation since the country repays more in real terms.

How to Control Deflation

  • Deficit financing: The government should spend more money than its revenue. This helps to increase aggregate demand and increase prices.
  • Use of an expansionary monetary policy: Banks should be encouraged to increase their lending to the public and so increase aggregate demand.
  • Use of a liberal fiscal policy: Taxes should be reduced so as to increase people’s disposable incomes and increase their demand for goods and services, with a consequent price increase.
  • Increasing wages and salaries: If wages are increased, people would have more money to spend. Demand would increase, thereby leading to the desired price increase.