What is deflation?
Deflation is a persistent decline in prices. If the price decline seen in recent months persists,it would be called deflation. However,every fall in prices is not called deflation.
How often does deflation occur?
Other than in Japan,for the years between 1999 and 2005 when consumer prices fell by an average of 0.5 per cent per year,the world has not seen serious deflation since World War Two.
How is disinflation different from deflation?
Disinflation is a fall in the inflation rate. So,what we have seen in recent months,with the inflation rate coming down from double digit levels to near zero,has clearly been disinflation. Prices do not have to fall in this situation. They merely need to rise at a slower and slower pace.
What causes deflation?
Deflation may be caused either by a shrinking of demand compared to supply,where there is an abundance of goods and so their prices decline; or it may be caused by a decline in money supply. When many industrialised countries tried to get rid of inflation and put their economies back on the gold standard after the second world war,they ended up in pushing their economies into deflation.
What are the costs of deflation?
When people see prices falling they tend to postpone consumption. If the fall in demand in comparison to supply has led to the initial fall in prices,this helps in reducing demand further and can lead to more deflation. This also encourages producers to postpone investment. The fall in demand from both investment and consumption can make deflation a self-fulfilling prophecy. If nominal wages are downwardly rigid,then we will see that real wage will be higher after deflation. This would mean that firms would not hire as much labour as they could at a lower real wage rate. Thus deflation could,in the presence of downward nominal wage rigidity,lead to higher unemployment. Firms and households who have borrowed money have to pay back greater amounts in real terms than they had contracted for if there is deflation. This is the opposite of what happens when there is inflation in which case the lenders lose and the borrowers gain. Now the opposite happens.
Is India likely to face deflation?
The decline in wholesale prices in India appears to have taken place due to the fall in world commodity prices. Prices of tradables are set either by the imported price of a commodity,and even if the commodity is not actually imported but it is possible to import it,by import parity pricing. The crash in world commodity price has thus led to a fall in domestic prices of a large number of goods. For most consumption goods we have not yet seen the transmission of lower input prices into lower output prices. However,if prices continue to fall,it would not be surprising to see that happen. One factor that acted against a fall in prices was the strengthening of the dollar. With the flight to US treasury bills of capital from around the world,the US dollar strengthened. If this had not happened prices in rupee terms the price of imporatbles would have fallen even more. Now if the dollar does not strengthen further then this source of moderation may go away and we may see more deflation. A third element of the story is that liquidity in the economy stopped rising after the global crisis. In the pre- September 08 era,before the death of Lehman,when dollars were flowing into India,RBI was constantly buying dollars pushing up money stock in the domestic economy. With the dollar flow reversing,RBI starting selling dollars to prevent the rupee from weakening too much. This meant the RBI sucked out rupees from the system. The reduction in growth of domestic liquidity has reduced inflationary pressures.
