Sunday, April 12, 2009

DEFLATION - Means decrease in prices. So why is everyone scared?

These days one of the most widely discussed topics in business media is the threat of the economy plunging in deflation.Various agencies are forecasting that India will slide into deflation somewhere in April end or May 09 and this has created lot of anxiety among the policymakers. Deflation by definition means lowering of prices of goods and services. Isn't this what we all always dream of ? So then why is everyone scared? Well there are reasons for that and will try and understand all the aspects of deflation and its effect on the broader economy and the common man.

What causes Deflation? Deflation is caused by general slump in prices of goods and services in the economy. The price destruction happens due to overall demand destruction for goods and services in the economy. Lower demand forces the producers of goods and services to lower their prices in a bid to push sales. The consumer on the other hand seeing price cut waits and expects further price cuts. This starts a cycle where prices keep falling.

How does it impact the economy? Deflation can be disastrous for the economy. Since deflation is caused due to demand destruction for goods and services the overall productivity and growth suffers in the economy.Producers loose revenue due to lesser sales and they in turn cut down on production, layoff people and thus people in general suffer due to job losses and lower income . This starts vicious cycle in the economy where lower demand means lower production and lower income for people .

How does it impact you and me? Since deflation causes massive job losses everyone including you and me will get affected. Self employed people suffer due to lower sales of their goods and services which results in lower income/closure of business units for them .

How can it be corrected ?Deflation can be corrected by reviving demand in the economy. Central banks can help prop up demand in the economy through proper monetary measures like lowering lending rates etc. Government too can help the cause by taking corrective fiscal measures like increased spending on infrastructure , social sectors etc.

Is India in Deflation today? India is not in deflation today. We are still inflationary economy . Rate of inflation is still in positive. If it turns negative (which it might) then we will be in deflation. Ideally, the best thing for any economy is to have low level of inflation. Low inflation keeps economy alive and kicking.

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