A Visual Guide to Deflation

From the folks at Mint.com and WallStats.com AVISUAL GUIDE DEFLATION Ok, so I think I understand inflation from last weeks guide, but what's this I have been hearing recently about deflation? Aren't they just opposites? Well, in the strictest sense, they are opposites, but deflation is really its own beast. ATTACK OF THE DEFLUTION IT WILL MAKE THINGS CHEAPER! So before things get confusing let's start with a definition. de fla tion (di-fley-shuhn) - n. 1. a fall in the general price levei or a contraction of credit and available money Ok, so prices go down. What's the problem here? The single biggest cause for concern is what is called the deflationary spiral. Yay! Stuff is cheaper. Companies make less profit on cheaper goods. Prices fall. Companies need to entice frugal Companies have to lay off workers to compensate. consumers with lower prices. Jobless workers do not spend money. If left unchecked, the entire economy grinds to a halt as joblessness soars. Woah, that's serious stuff. That's right, and it's very difficult to stop once it gets going. With deflation, the value of your cash is increasing, and you don't have to do anything. Hoarding $1,000 under your mattress becomes a good investment strategy, because the value of money is going up. With 1% monthly deflation, your purchasing power rises. $1.010 $1,030 $1,126 After 1 month.. ..3 months... ..a year.. You will still have $1,000 under the mattress, but its purchasing power would be equivalent to $1,126. Consumers have little reason to spend and make big purchases if they know the price will always be lower. But shouldn't this apply to business as well, if the cost of everything goes down, shouldn't the cost of making things go down. This is partly true. the price of cars will go down, as will the price of steel used to make those cars. but labor is sticky in the downward direction. Here are two scenarios: Inflation is 3% and Deflation is 3% and you get a 2% raise. you get a 2% pay cut. 2% PURCHASING PURCHASING POWER POWER 3% 3% The second situation is more beneficial because your net purchasing power is increasing. But I don't want a pay cut. Exactly. The effects of inflation and deflation are not very visible and workers generally see their paychecks in nominal terms. To most people a pay cut is a pay cut. Which is why it's hard to adjust ges downward for deflation. Correct. Gotcha. So what causes this deflation business, and what can we do about it? Like many things in economics, it's essentially about supply and demand. Deflation can occur when there is an increased demand for money, an increased supply of goods, a decreased supply of money or a decreased demand for goods. And how does this happen? There are several ways to start deflation. Central bank raises interest rates to A bubble is burst causing banks to fail. People default on their loans. control inflation. Credit tightens, less money is loaned and therefore, spent. Deflation begins. This is why it's important that banks do not fail. For better or worse, the US has a credit based economy which is driven by banks and borrowers. Will deflation always lead to a deflationary spiral? I mean, can't we do something about it? There is a remedy. It's similar to how we fight inflation, with the Federal Reserve adjusting interest rates. By lowering the rate, the money and credit supply is increased. So to stop deflation, we must cause inflation? Essentially, yes. But there is one major problem. With inflation, the Fed can raise rates as much as they need to. But with deflation, the rate cannot be lowered beyond zero. This is called the Liquidity Trap Stimulate the economy and fight deflation. Slow the economy and fight inflation. Fed Rate 1% 2% 4% 5% The closer the Fed pushes the rate to zero in an effort to stimulate the economy, the less options it has to fight deflation. Liquidity Trap Deflationary Spiral Depression If the rate is already at or near zero due to some financial crisis or stimulation effort, then there is little the Fed can do to stop deflation. That doesn't sound good. It's the stuff depressions are made of. Great ones. Woah. There has got be something else that can be done. You know, besides the Fed. Well, there is. The government can inject money into the economy with massive spending. This creates jobs and incomes. Which creates the security, That allows people to open up their pocket books and start spending. Which puts dollars back into the economy and reduces deflation. You see reversing deflation requires more than an economic model. One has to foster the psychological condition that things are indeed going to improve, and that it is ok to spend money, because you will still have your job down the road. Ok I think I got it. So let's recap. When there is not enough money or credit available, deflation occurs. Holding on to money is better than spending it so companies cut prices, which leads to cheaper stuff, but also layoffs, and further price cuts. No one is spending and the economy tanks. The Feds can increase the supply of money unless the interest rate is already near zero, in which case more direct action has to be taken. Oh, and think positive. Right on. You'll be an expert in no time. Sweet! Inflation and deflation aren't that complicated after all. What else you got? Stay tuned next week as we journey to the economic twilight zone to learn about.. .Biflation. Mint.com/blog/ WallStats.com