Why deflation is dangerous than inflation?

tojo jose
August 27, 2015

Deflation refers to the situation of general decline in prices. General decline means prices of
most commodities and services are coming down. It is the opposite situation of inflation.

Causes of deflation

Deflation is generally caused by reduced demand and consumption in the economy. Reduced
expenditure by consumers, business people and government brings down demand and thus causes
deflation. Lower demand means reduced takers for goods and services and in this way prices of
commodities will come down to make them saleable.

What makes the consumption, investment and government expenditure to decrease? There are
many factors – reduction in money supply by the central bank, reduced credit or loans by the
banking system, decreased investment expenditure by business people and reduced budget
spending by government; all causes decline in demand and produces deflation.

Why deflation is dangerous than inflation?

Both inflation and deflation are bad for the economy. But of the two, deflation is more
dangerous. If prices of goods are coming down, business people will stop investment as there is
the risk of loss. In this way, deflation discourages many desirable factors in the economy –
production, investment, employment and thus economic growth.

The major side effect is that it is a disincentive for the producers. Gradually, deflation can
worsen into a recession and depression. It is often said that among the two undesirables-
inflation and deflation; deflation is more dangerous. Deflation discourages the business
psychologically. It adversely affects business momentum. Massive deflation may develop into
depression as happened during 1920s. Hence, Central banks always try to avoid deflation.

On the other hand, in the case of inflation, mild level of inflation incentivizes production and
investment activities. This in turn increases level of employment and economic growth. From the
angle of business momentum low inflation is a desirable factor.

The definition of price stability also tells us that low level of inflation is preferable to deflation.
Price stability is the most important objective of central bank’s monetary policy. Price stability is
defined as low and stable inflation. There is no meaning that price stability is absence of
inflation. Rather, low level of inflation is a welcome factor that may stimulate the economy.

In India, the RBI considers that 4% inflation is good for the economy. In the US, the central bank
has a 2% inflation target.
Why deflation at present in many developed countries?

At present, deflationary situation prevails in most developed countries. Countries like US and
Japan are designing monetary policies to achieve a target level of inflation. Still, inflation
doesn’t occur in these economies.

The main reason for deflation in these economies is low consumption and low investment
expenditure. Overall demand is low in these economies. There are no takers for already produced
commodities. Because of the low demand, there are no incentives for businesses to expand
investment. Deflation in these economies raises unemployment and brings down economic
growth.

Which of the two is better- inflation or deflation? Inflation is a phenomenon of rising prices without causing
change in the levels of employment and output. Deflation, on the other hand, is a phenomenon of falling
prices accompanied by a fall in the levels of employment and output. Both inflation and deflation are
harmful for society and have undesirable economic consequences.
But when the question of a choice between the two evils of inflation and deflation arises, the lesser evil is to
be selected. An inflation is the lesser evil. Thus, inflation is preferred to deflation because the former is
lesser of the two evils. In the words of Keynes, “Inflation is unjust and deflation in inexpedient. Of the two
deflations is worse.”
Inflation in Unjust:
Inflation is considered unjust in the following grounds:
(i) Inflation redistributes income in favour of the rich (profit earners) at the cost of the poor (wage earners
and consumers).
(ii) Inflation increases economic inequalities through its redistributive effect. It transfers purchasing power
from poorer to the richer sections of the society and thus widens the gap between the rich and the poor.
(iii) Inflation is regressive in its effect. It adversely affects those who are already weak and cannot protect
themselves. It specially hits the middle classes who suffer most during inflation.
(iv) Inflation affects different people differently and in different degrees and thus alters the economic and
social relationships in the country. It takes away wealth from some groups of the society and transfers it to
others arbitrarily, ignoring the maxim of equity.
(v) It is socially demoralising. It encourages the spirit of gambling. It promotes speculative activities and
diverts business skill and efficiency from productive to speculative activities.
(vi) It creates money illusion and results in artificial prosperity which is short-lived.
(vii) It reduces the value of money and thus erodes real saving of the people.
(viii) When the government adopts the inflationary method of deficit financing to cover up the deficit in its
budget, the prices go up and this inflationary rise in prices diverts the goods and services meant for public
consumption to the government which is totally unjust and unequitable.
Deflation is Inexpedient:
Deflation is considered inexpedient because of the following reasons:
(i) Deflation, by reducing prices and output, leads to a sharp decline in the national income and thus reverses
the process of economic growth.
(ii) Deflation results in mass unemployment. Reduction in prices and profits forces the businessmen to close
down their establishments or reduce their production, thus giving rise to large-scale unemployment.
(iii) Deflation leads to depression in the economy. Downward trend of prices and production gives rise to
pessimistic conditions in the economy; economic activity contracts; scale of production is reduced, volume
of investment falls; and no new investment is forthcoming due to depressed profit expectations.
(iv) Deflation, once starts, becomes cumulative. It goes on gathering momentum and the economic crisis
becomes deeper and deeper with the passage of time.
(v) Deflation is undesirable from all sides. It adversely affects the social, economic, political and moral life
of the economy. It curtails economic activity, causes mass unemployment, generates poverty and ultimately
results in the complete ruin of the economy.
Inflation is better than Deflation:
Though both inflation and deflation have undesirable effects, but inflation is considered better than
deflation.
The following arguments justify the preference for inflation:
(i) Inflation, though it redistributes income and wealth in favour of the rich and causes economic
inequalities, does not reduce national income. Deflation, on the other hand, has the undesirable effect of
reducing national income.
(ii) Inflation is a post-full employment phenomenon, while deflation is an under-employment phenomenon.
In other words, during inflationary phase all factors of production are employed in some way or the other,
whereas, during deflation, the problem of unemployment becomes more and more acute.
(iii) It is easy to control inflation by adopting various monetary and fiscal measures, but it is very difficult to
recover the economy from deflation. Once deflation starts, it gathers momentum and the cumulative
downward process ultimately takes the economy into severs depression.
During depression, the marginal efficiency of capital declines and the businessmen become pessimistic
about the future of their investments. Under such conditions, monetary and fiscal policies become
ineffective; they cannot restore the confidence of the entrepreneurs and compel them to increase investment.
(iv) Mild inflation is better than deflation from the point of view of economic development. Moderate
monetary expansion by raising the price level and increasing the expenditures, can stimulate
economic development in a depressed economy.
(v) Inflation is lesser evil- (a) Inflation is a single evil because it redistributes wealth in favour of the rich
people arbitrarily. Deflation is a double evil because it not only redistributes wealth in the same arbitrary
manner, though in favour of the poor people, but also, reduces output and causes unemployment (b)
Inflation makes it increasingly difficult for the people to earn a good livelihood, while deflation deprives the
people of their livelihood by rendering them unemployed; in other words, in inflation, people do not get
enough, in deflation, they do not get anything at all.
In the end, it is true that Keynes prefers inflation to deflation. But, this does not mean that he is an
inflationist. His preference for inflation over deflation is only a matter of choosing the lesser evil.
In fact, nowhere has he preferred inflation over the objective of full employment. He fully realises the
dangers of inflation, particularly when it gets out of control and turns into hyper-inflation.

Deflation defines a downward trend in the cost of goods and services. Recession marks a
widespread dip in economic activity. An economic depression, less easy to define, is a
protracted recession.