The Price Level and Inflation: Deflation

Deflation The preceding discussion concentrated on only one aspect of price instability: inflation. What about deflation, which occurs when prices are unstable on the down side? What are the consequences of reductions in the price level? As is the case for inflation, the impact of deflation on income depends on how that income varies when the price level falls. The Great Depression of the 1930s was also a period of deflation. Between 1929 and 1933 the CPI declined by 29 percent while nominal wages fell by only 18 percent in manufacturing and 21 percent overall. As a result, real wages during this period increased by 8 percent and by 11 percent in manufacturing? However, we can't conclude from this that workers gained from deflation, because high unemployment rates during the Depression years of 1929-1933 reduced labor income in the aggregate despite the increase in real wages. Deflation increases the purchasing power of a dollar over time. Deflation benefits creditors because the dollars they receive as loan payments have higher purchasing power than those they lent. During periods of deflation, real interest rates tend to soar. For example, if you look back at the graph in Box 6, you'll notice that during the Depression of 1929-1933, real interest rates on government bonds approached 15 percent. How Price Instability Affects The Performance Of The Economy Price instability, or more accurately the actions taken in anticipation of it, can adversely affect the performance of the economy. When buyers and sellers try to guess what price instability will do to the purchasing power of the dollar in the future, they also base their decisions in part on the gains or losses they might incur as a result of inflation (or deflation). The resulting shifts in supply and demand in individual markets cause distortions in market prices. For example, suppose everyone thought that inflation was going to erode the real value of their savings. This would cause the supply of savings to decrease, which would make interest rates higher than would be the case in the absence of inflationary expectations. Anticipated Inflation and Economic Decisions You've undoubtedly gotten used to the fact of inflation over your lifetime. If you're like most people, you've probably made purchases today that you might otherwise have put off to the future because you anticipated that inflation would increase the price of the product. For example, if you anticipate a 10 percent price increase in the stereo system you really want to have for next year when you move out of your dorm into an apartment, you might choose to buy it now rather than next year. Similarly, when signing a lease for an apartment or borrowing money, you've probably considered what inflation would do the burden of making rent or interest payments. Inflation makes it hard to collect information about what constitutes a reasonable price for an item. You never know whether prices for a good have gone up because of shifts in the supply of and demand for that item or because of general inflation. This makes it difficult to decide what to buy and when to buy it. Anticipated inflation will affect the choices we make as individuals. Those who correctly anticipate the impact of inflation on their incomes can avoid the reduction in real income and wealth that inflation will cause. For example, if lenders correctly anticipate inflation, they can seek to avoid its undesirable effect on their real income by trying to attach an inflation "premium" to the nominal interest rate they charge for new loans. Businesses also consider inflation when placing orders. For example, businesses might stock up on parts and raw materials in expectation of future price increases. When inflation is steady and predictable, many people are likely to correctly anticipate its effects on the purchasing power of the dollar. However, when inflation is erratic, fewer people will succeed in anticipating its effects. The actual impact of inflation on the distribution of income between workers and their employers and between borrowers and lenders will depend on how accurately inflation is anticipated by each of these groups.