Firm behaviour during deflation

Abstract

Deflation is the phenomenon of reduction in overall price levels of goods and services in the economy. It is the excessive growth in the demand for money in the economy. Though it may look like the consumers are better off as now they can buy more, it hurts the economy by reducing demand. Financial institutions, corporates and the customers behave differently during a deflation time. Consumers anticipate future drop in prices. This puts pressure on producers to further lower the prices which will result in cost cutting practices. This means lower wages and lower investment spending. Ultimately, it will slower the economic growth. That is why famous English economist John Maynard Keynes called deflation as worse while comparing with inflation. During deflationary period, the real value of both money and debt increases, which makes it more difficult for a debtor to pay off their debt. Firms will have to spend more to repay their debt which will translate to lower wages. Deflation causes more deflation; this is called deflation spiral. Falling prices will lead to lower confidence, which leads to lower spending, and hence even lower prices. Why 2% benchmark - The widely accepted healthy benchmark for inflation is 2%. Around one fourth of the global economies are below this benchmark and half of them are facing deflation. So, this benchmark is used by the federal reserves to protect the economies from deflation.