Effects of deflations to the economy

ECONOMIC ARTICLE

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Introduction

Deflation has been defined by many economists and financial experts as the decrease in the price of a certain good, asset or service compared to previous market prices. This economic phenomenon has various effects on the economy of the subject country, and this paper shall address some of them with a view to justifying the Federal Reserve’s response to the same.

Effects of deflations to the economy

Deflationary forces lower the prices of commodities affecting the improvement of production efficiency (Economywatch.com, 2015). Since the production efficiency of a country is directly dependent on the promise of higher profit margins, and results to higher quality goods, it releases pressure on the producers to push the costs of increasing the quality of their products to the consumer thus resulting in lower prices. Therefore, deflation leads to lower consumer prices and an increased purchasing power.

The effects of deflation on the economy of a country are negatively biased in terms of its effect on liquid asset owners and borrowers. By acting as a form of tax on these individual parties, deflation also benefits liquid cash holders and owners of assets and this condition introduces a certain level of risk to the economy known in economic circles as the liquidity trap (Bernanke, 2000). Herein, encouraged by the negativity of risk-adjusted asset returns, the purchasers and investors are enticed to pool money instead of investing it in guaranteed securities.

Investment activities and expenditure are discouraged by deflationary forces a decline in the economy’s aggregate demand and an introduction of the deflationary spiral. This is characterized by a fall in the prices of goods produced as the situation deteriorates to a vicious circle as witnessed during the American Civil War. Herein, the country’s fiscal authority acts quickly, depending on the rate of deflation, to increase demand by lending money at lower interest rates than those offered by private commercial bodies.

Deflation also affects the economy by increasing the velocity of money, at least according to the Monetarist views (Fujiwara,2007). Herein, the number of monetary transactions is reduced rather permanently and results in an acute shortage in the supply of money with heavy effects on the industries dealing in exportation and importation activities.

Should the Federal Reserve Bank be concerned?

The Federal Reserve Bank has every right toke be concerned with the effects that deflation has on the United States economy. But unlike the Great Depression of the 1930’s, contemporary depression would be the result of far more complex factors that production aspects. In fact,according to recent research, there is a need for a small degree of controlled deflation to maintain the interest rates in the United States in the optimal regions nearer to zero, after all. According to Milton Freidman, there is a need for “optimal monetary policy to maintain the nominal rate of interest at zero”(Clement, 2015). Although this has been mentioned above as a negative effect of deflationary forces, the current state of the American economy needs to stay as near to the liquidity trap as possible, without reaching it. This has been demonstrated to hold the key to reducing the current economic inefficiencies due to a variety of reasons.

Therefore, the Federal Reserve needs to embrace some small, but controlled degree of deflationary force in the American economy to deal with the inherent inefficiencies in the contemporary economic conditions.However, the devastating effects of the same economic conditions should not be forgotten as the harsh conditions of the 1930’s still remain etched in the minds of Americans. Therefore, there is a need to monitor carefully this deflationary allowance.

References

Economywatch.com,. (2015). Effects of Deflation | Economy Watch. Retrieved 16 January 2015, from http://www.economywatch.com/inflation/deflation/effects.htmlBernanke, B. (2000). Essays on the great depression. Princeton, N.J.: Princeton University Press.

Fujiwara, I. (2007). Japanese monetary policy during the collapse of the bubble economy. Tokyo: Institute for Monetary and Economic Studies, Bank of Japan.

Clement, D. (2015). Retrieved 16 January 2015, from http:///www.minneapolisfed.org/publications/the-region/deflation-should-the-fed-be-concerned.c