Josef Sima:Deflation is a term used to denote situations of a general
decline in prices, a falling price level. For most of the history, such
coincided with prosperous times. However, 20th century changed
that perception. Prices have been systematically on the rise-inflation has
become a part of our life, (e.g., prices in the US multiplied between the
years 1900 and 2000 approximately 25 times, as opposed to 50% decrease
between, 1800 and 1900.) Rather than a sign of prosperity, deflation is
today often - though mistakenly -taken to be the cause of crises and
; economic breakdowns. In the following text, I will explain what economic
forces can cause prices to fall and bring some light to the consequences of-deflationary policies'.
It might be useful to start tackling the issues of deflation by noting that
deflation (and inflation) originally meant a great decrease (increase) in
the supply of money, rather than its inexorable consequence - the general
tendency towards a fall (rise) in prices- which is what it means today. This
shift in meaning may easily cause confusion: e.g., in a rapidly growing
with an increasing money supply but decreasing price level, our
predecessors would - using the original definition - speak of inflation,
whereas, today, we would describe it as deflation. Let us see now, in what
prices typically fall.


Deflation as a Result of Economic Growth
kind of deflation is a natural state of a dynamically developing
economy. As a result of growing productivity, more and more goods are
produced in the economy and, consequently, producers have to compete over
> existing money units, against which they supply their products. Assuming a
> given quantity of money, it follows that the value of money will go up,
> which means that more goods can be bought for a unit of money. Prices will
> have a tendency to fall. Money will keep acting as the medium of exchange
> and the resulting prices will precisely mirror market participants'
> preferences and underlying resource scarcity patterns. Therefore, the
> economy will not waste resources, which is a precondition for further
> growth. As rational economic calculation is possible under these conditions
> (prices correctly reflect the relevant market `data'), there is no reason to
> expect any obstacles for successful economic development. Such a development
> is a typical one for periods between several inflationary episodes in
> history generally initiated by states for the sake of waging wars. In the
> US, between 1880 and 1896, we can, for example, see a decline of wholesale
> prices by some 30% (which amounts to an annual fall of 1.75%), whereas real
> income went up by some 85% (which is 5% annually). Even today, despite the
> continual inflation orchestrated by central banks, there are sectors
> experiencing a boom within a `deflationary' environment (decline of their
> products' prices)- the most flagrant example being the electronics industry
> (computers, video and DVD-players, TV-sets, cell-phones, etc.). What is of
> interest to producers is the spread between buying and selling prices, i.e.,
> input-output spreads that give rise to profits. Changes in some `price
> index', which captures the changes of overall prices, are of no real
> importance to them.
>
>
> Deflation As a Result of Hoarding
>
>
> For many people, hoarding embodies a veritable bogey as it causes money to
> `disappear' from the economy. What hoarding means, however, is that some
> people for certain reasons, (such as uncertainty about their pensions)
> decide to increase their cash holdings. In this situation, it is only
> natural that selling the existing stock of goods for less money units will
> be possible only if the purchasing power of the money unit increases - the
> higher demand for money units pushes their price, in terms of goods, up.
> This adjustment is, strictly speaking, a productive activity - some people
> decided voluntarily not to exchange their money for so many goods offered as
> before, because they value holding cash more than the goods they could
> obtain for that amount of cash. The result is deflation, i.e., a new
structure of prices corresponding to the new market situation that emerges
in the same way as any new price pattern accommodating any change in
people's behavior, (e.g., a change in fashion).

Credit Deflation

We will now explore the third situation causing prices to fall. In modern
history, we can find several instances in which people, typically as a
of previous inflation and subsequent financial crises, started to
their demand deposits from banksen masse. As they withdraw their
money (or in the past redeemed gold), banks are driven into liquidity
problems that may ultimately lead to their bankruptcy. This intensifies the
crises, as more and more clients lose confidence in the overall health of
the banking sector and therefore come to their banks and demand that the
> deposits on their accounts be paid off. Banks attempt to accumulate their
> reserves in order to become able to fulfill their obligations. The
> accumulation of reserves (historically gold) leads towards a decrease in
> money supply, resulting in an increase in the value of money - prices fall,
deflation is underway. Before World War I, central banks themselves several
times initiated such a deflation to prevent the breakdown of the banking
system. Deflationary periods of that kind were typically very short and
swift, and so was the elimination of unavoidable results of previous
inflations.

Confiscatory deflation

Whereas the previous kinds of deflations were market-driven, now
confiscatory deflation is orchestrated by the state authorities by
people from using their cash in an attempt to solve the
' in the money market created by a preceding inflation. The case
of Argentina from the first years of the 21st century can be listed as an
example. Supply of money shrank and prices went down.
> As we have seen, deflation can be one of the result of economic problems,
> such as banking sector collapse. Under normal circumstances, however, if new
> money is not pumped into the economy it is a reflection of economic growth -
> a certain quantity of money chases more goods-and allocation of resources is
> guided by consumers' preferences. The pattern of income corresponds to the
> productivity of market participants, rather then being influenced by
> politically induced monetary shocks. On the other hand, the attempts to
> increase the money supply to fight deflation often lead to redistribution
> (as it equals taxing the cash-holdings) , discoordination and hence waste of
> resources (as price signals get wrong).
> Shobha Ahuja:From 2003 to early 2008, the world witnessed the most marked
> commodity price boom of the past century. The prices of oil, metals, food
> grains, and other commodities rose sharply, and over a sustained period. But
> the global economic crisis has reversed the commodity price boom in the late
> 2008 with commodity prices, notably the oil prices, falling sharply in the
> last six months. Besides, there is a sharp decline in metal and food prices
> as most countries have started experiencing excess (supply) capacity and a
> contraction in demand. These price declines have dampened growth prospects
> for a number of commodity-exporting economies. According to IMF projections,
> headline inflation is expected to decline from 3.5% in 2008 to a record low
> 0.25% in 2009 in the advanced economies, before edging up to 0.75% in 2010.
> India, too, is facing the prospect of negative inflation, as measured by the
> Wholesale Price Index (WPI). However, the paradox is that the Consumer Price
> Index (CPI), which measures inflation at the retail level, is still at
> double digit level. And there are a range of products within the WPI which
> are still rising. High food prices are still a cause for concern. Hence, at
> present, the fall in WPI is seen as a corrective mechanism from the high
> prices ruling in 2007-08 and the specter of falling prices is not so much a
> threat to our growth prospect.
> Indeed, our growth story is intact, even though it is weaker than last year,
> there is demand in the economy and investments are still taking place.
> However, if prices continue to fall, a prospect which we do not anticipate
> to hold for long , then it could be a setback to growth

Caught in Deflationary Spiral?
With the deterioration taking place in the global economy, the prospect of
outright deflation - and all the risks that it entails - is a clear and
present danger. The prospect of deflation in countries like US, Europe and
Japan is very much real, given the recession in their economy. The prospect
of falling demand and possibly falling prices is something that is catching
attention of policy makers the world over. Hence, the phenomena should
not be dismissed as a statistical quirk.
the current scenario, prices are falling, not because of improved
productivity, but because of fall in demand. The fall in demand and prices
> is adversely affecting the bottom line of companies and the manufacturing
> sector is not finding any incentive to increase production. If deflation
> sustains for a long period of time, it will lead to lower production and
> investment as industry would not invest in capacity addition. A fall in
> demand would result in lower wages and unemployment, which, in turn, would
> lead to further decreases in prices, causing a deflationary spiral. However,
> in India, the southward drift of inflation, which is now closer to zero, is
> more as a result of high base effect apart from falling oil and commodity
> prices. No wonder, policy makers have termed the phenomenon as disinflation,
> rather than deflation. Hence, near zero inflation is temporary and is
> anticipated to again show an upward trend once the statistical bias accruing
> from the high base effect, which compares present inflation levels from that
> prevailing during the same period last year, wears off.

WPI vs. CPI
phenomenon of measuring inflation on the basis of WPI is unique to
India. All major countries across the world measure inflation on the basis
of CPI or the Producer Price Index (PPI). Hence, this question pertains more
to India than to the rest of the world.
The plunge in WPI was mainly driven by the fall in prices of industrial
commodities and raw materials. The near zero inflation rate is largely the
of the dramatic decline in energy and commodity prices over the past
. For example, oil prices fell from the high $109 in September 2008 to a
of $37.4 in 2009. However, the WPI takes prices at ex factory level and
made up of a large number of primary, intermediate and manufactured
items. Excise duty, marketing costs and rebates are not reflected in WPI.
that matter, much of items which form the household consumption basket
> have a low weight in WPI. CPI measures inflation experienced by consumers at
> retail outlets. The weights assigned to items taken for measuring inflation
> are different. CPI assigns higher weight for items which are consumed by
> households. For example, the weight attached to food and beverages, etc.,
> account for nearly 48% in CPI, but around 28% in WPI. Likewise, fuel has a
> weight of 6% in CPI but over 14% in WPI. However, a decline in WPI would
> most likely be captured by CPI in times to come when the impact of price
> fall percolates down to the retail level.
> To reconcile the WPI and CPI and to have a cogent measure of inflation, it
> is imperative that we move towards a new measure of inflation given by PPI.
> This is presently being contemplated by the government.

Before the Central Banks

- Sufficient injections of money will ultimately reverse deflation.
- Increased government spending in areas, such as infrastructure and
housing.
- Global monetary and fiscal policies can provide substantial support.
- Fiscal policies and rationalization of taxes which would lower
production costs of industry and spur demand.

Less than a year ago, inflation was a major concern for many of world's
economies. Now its opposite, deflation, is emerging as the latest threat,
which could make the global recession worse if it takes hold.