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The dangers of deflation

6355336039_1b107e5054_zDeflation is the term used to describe a situation in which there is a sustained decline of general prices of goods and services during a certain period of time. Consequently, a person like us, a random consumer, could think that this situation is good as it allows us to increase our purchasing power, enabling us to buy more goods with the same amount of money. And this is true up to a certain amount of deflation, but it can be a symptom of a dangerous economic illness when it reaches very low rates of inflation. Thus, it can lead to a deflationary spiral, a situation that all Governments try to avoid.

A deflationary spiral occurs when a decrement of prices leads to a lower production, reducing the demand in such a manner that even the low prices cannot stimulate it. Obviously,  when the production goes down, it gets necessary to compensate the companies’ losses by reducing the wages, leading people to spend less and, therefore, reducing the demand. That forces the company to drecrease prices even more, eventually aggravating recessions. Therefore, we have a vicious circle in which deflation itself exacerbates its own problem. However, this is not the only issue that it carries; deflation is a big issue in a modern economy because it increases the real value of debt, and taking into account that Spain recorded a Government Debt to GDP of 93.90% of the country’s Gross Domestic Product in 2013, deflation is a serious threat for us.

Notwithstanding, deflation is not always a negative feature. Experts consider that there is a “good deflation”, which consists on the ability to constantly produce goods at lower prices due to efficiency reasons.

Be that as it may, there are two traditional ways to fight against deflation. The first of them is the possibility of reducing the interest rates, which will help families to get credit in order to reactivate the purchasing process. The second one is a typical Keynes solution; it could be useful to increase the public expenditure, which could compensate the lack of private expenses. The best way, as experts indicate, is a combination of both measures in order to overcome the inflation period as soon as possible.

In the case of the Euro zone, where the risk of deflation has been widely commented in recent days, the situation is even more problematic as these countries (including Spain) depend on the European Central Bank (ECB) to reduce the interest rates. Notwithstanding, the president of the ECB, Mario Draghi, has pointed several times that the European institution will do its best to avoid this economic situation.

 

 

 

Author Spotlight

Gonzalo Andreu Candau

gonzaloandreu
Bachelor student in Law and Business Administration by Seville University. Former exchange student in Chile and The Netherlands. Read Full

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