Deflation increases the value of money over time. During the times of deflation, prices in a country will have the persistent tendency to decrease. Sounds good, right?
There are obviously both advantages and disadvantages of deflation that we should consider before making any final statements.
Advantages of deflation
Here are a few ideas how customers and businesses might benefit from deflation:
- Higher purchasing power of customers. If there is deflation in the country, prices decline. Workers’ wages and managers’ salaries will buy more goods and services than before. It will benefit especially poor people and middle class whose monthly spending gets reduced dramatically. When people’s real incomes increase, they will feel richer, therefore more satisfied with their lives.
- Lower Variable Costs (VC) leading to higher Gross Profit. Firstly, prices of raw materials that are used to produce goods and provide services will decrease. Secondly, production workers will not be asking for higher wages because now they will be able to buy more products with the same amount of money, as their money is gaining value. Deflation will lead to lower Variable Costs (VC) that decrease the cost of production, or Cost of Goods Sold (COGS), therefore increase Gross Profit.
- Lower Fixed Costs (FC) leading to higher Net Profit. Firstly, firms will now pay cheaper rent and the prices of land, buildings and office space will most likely decrease as well. Secondly, managers will not be asking for higher salaries as now they are able to buy more products with the same amount of money. This will decrease Fixed Costs (FC), or expenses, therefore increase Net Profit.
- Narrows the gap between rich and poor. In a way one can say that deflation helps in narrowing the gap between the rich and poor. As deflation causes a decrease in the value of financial assets, it becomes very hard for citizens to accumulate wealth. This will hit many rich people who tend to hold more wealth-building assets such as apartments, houses, office buildings, land, businesses, etc. as compared to poor people. We can say that during inflationary times, it is the rich people who benefit, while during deflationary times it is poor people who benefit more.
Disadvantages of deflation
Rapid inflation has many serious side effects. While we could conclude that a period of falling prices could be positively desirable, here are some reasons why most customers and businesses would not actually benefit from deflation.
- Delayed consumption. Individual consumers will put off spending money on buying cars, furniture, home appliances, etc. as they expect prices to fall. People will also delay making important purchases such as buying a house or apartment hoping that prices would fall further in the future.
- Lower demand. If everybody in a country reduces their spending waiting for times when prices are much lower, then many companies could fail due to lack of demand. Although lower prices sound like a good thing, many employees might lose their jobs. This reduction in demand would cause higher unemployment which could further lead to a serious economic recession.
- Lower supply orders. Holdings of stocks of raw materials and finished goods will be falling in value. Businesses will hold less inventory, in fact, as few stocks as possible. It is because with deflation, prices are expected to be cheaper in the future. So, orders for supplies from other businesses in the primary sector will be reduced. This is another factor that could push the economy into recession as output declines.
- Higher real value of debt. In deflationary times, current amount of money buys more products while the debt amount taken a few years back stays the same. It means that you are actually paying more – that money now could have bought more products. Deflation increases the cost of your debts, because during deflation, you have less but of more valuable money. Because the value of money is increasing, when a debt is repaid it is repaid with money of more value than the original loan. Businesses with long-term liabilities would find that they were making interest payments and debt repayments giving away valuable money that have gained in value since the original loan was taken out. This article ‘The Effect of Deflation on Debt’ clearly explains this phenomenon.
- Lower value of Fixed Assets. The value of Fixed Assets such as land and buildings will decrease. This will then decrease the value of a business on the Balance Sheet making the company less financially secure as it theoretically has less collateral.
- Less investment. As prices fall during deflation, so the future profitability of new projects. This may make some firms unwilling to commit funds to further investment. Ultimately, deflation will discourage customers and businesses from borrowing to invest.
Overall, businesses will ultimately lose both during times with rapid inflation and rapid deflation. Therefore, everyone agrees that the correct decision for most economies is to tolerate low rates of inflation of approximately 2%, while carefully observing and taking appropriate timely measures when the inflation rate goes too high or too low.
