EFFECTS OF DEFLATION

The effects of deflation are opposite to those of inflation. We can study these effects under two heads.

1. Effects on Production and Employment

Deflation has adverse effects on production, income, employment and hence on economic activities. During deflation, prices of goods and services are falling due to contraction in their demand. Continuous fall in prices may cause heavy losses to the firms, forcing them to go into liquidation. Many firms close down their plants or leave a part of the plant capacity idle. In such situation, the whole economy is gripped by pessimism and depression. Investors hesitate to invest. Once started, depression is self generating. Worst type of depression was noticed in the United States during early thirties. During 1930-32, about 5,000 banks failed here resulting in huge loss of accumulated savings of about a million people. Business profits sank to zero. Formerly prosperous businessmen could be seen on roads. The worst sufferers were the workers whose average wage bill fell drastically. Many of them lost jobs to live under appealing conditions.

2. Effects on Distribution

All those economic groups who gain during inflation tend to lose initially during deflation and vice – versa. Producers, merchants, speculators and farmer lose due to fall in the prices. Due to continuous erosion of effective demand, involuntary accumulation of stocks takes place involving storage cost. Further, prices of end product fall at far greater rate than their costs, most of which tend to be fixed and sticky downward. Due to fall in demand and prices, their  profit margins dwindle down. Businessman also suffer in the capacity of debtors, when they repay these debts in money, which has more value due to deflation. Their bankruptcy which results in non-payment of loans is not beneficial to them.

Consumers, fixed income earners and creditors get immediate gains as a result of deflation. Their income will fetch more goods and services because of rise in the value of their money. Increased purchasing power raises the real values of wages, salaries, interest, rent, etc. A careful thought reveals that ultimately all economic groups are adversely affected on account of deflation. At low prices, businessmen have no inducement to expand the size of output or even to continue the production activities. As a result, most of the factors are rendered unemployed. There are drastic cuts in the wages. Retrenchment of workers on a large scale leaves them jobless. Creditors who are supposed to benefit by receiving back greater purchasing power in terms of principal and interest thereon, may lose even their principal as bad debts due to suffering and misery all round.