Deflationary Spiral
A deflationary spiral is an economic concept. It refers to a situation in which the prices of the commodities decrease on a substantial basis. But the situation becomes worse as the economy cannot recover after this reduction in prices. Thus, it leads to a viscous cycle of low prices and increasing deflation. Hence, it is called as deflationary spiral.
Inflation refers to increase in prices of commodities while deflation is the decrease in prices. In order to overcome deflation, banking and monetary authorities in the country try to expand the monetary policies for maintaining economic growth. However, in some situations, the economy is weaker to cope or the interest rates have almost reached zero. This leads to failure of monetary policies. A deflationary spiral occurs at this stage even though the monetary policies have been expanded.
Situations that lead to deflationary spiral
The situations that lead to deflationary spiral are:
- Recession
- Economic depression – weakening of the economic status of the country
- Reduction in the economic outputs of the country
- Reduction in demand for investment as well as spending
What happens in a deflationary spiral situation?
The prices of the assets, goods and services are decreased. Companies keep on decreasing the prices as they want to finish their stock. Consumers are having many affordable and competitive options in the market. But they do not carry enough cash to shop luxury items or essential goods. They try to hold cash for future and do not invest it. Fewer saving and less spending leads to decrease in demand. As consumers attempt to hoard maximum amount of money expecting that the inflation rate will increase in future. This is perhaps the thinking of an ordinary person.
A person will not buy if he expects that the price of the commodity is going to decrease after two days. He will keep on holding cash and won’t buy until the price goes down. He will become stubborn and will not buy even after two days. He will expect that the price of that commodity will lessen even after a week. Hence, the cash hoarding tendency of the people increases to a greater extent in situations of deflationary spiral.
A vice known as unemployment
The significant impact of deflationary spiral is unemployment. Unemployment creates miserable conditions for the people. It has a tremendous impact on the companies and the economy as well. As the company wants to boost its revenue, it takes steps such as cutting off wages, a number of positions. The reduction in workforce creates unemployment.
The unemployed people have less cash at their disbursal to buy everyday commodities. Hence, the borrowing capacity of these people also decreases with respect to loans, mortgages and credit cards. The banks and financial institutions suffer from collapses as no one is interested in borrowing from them despite of the lower interest rates. Later, they do not provide credit to the needy people and reduce their lines of credit.
Thus, deflationary spiral can be compared to a dry winter condition. The effects are intense as well as can be observed in the long run.
Deflationary spiral is the result of deflation. When deflation goes beyond the control of financial authorities, a vicious circle of deflationary spiral arises. It is very difficult for an economy to come out of this circle. Deflationary spiral has many adverse effect likes unemployment, decline in the value of currency, decrease in demand, etc. An economy has to design stringent policies to outlast the deflationary spiral. Getting rid of all the debts, making monetary policies to promote economic growth and making efforts to re-establish the currency’s original value can help an economy outlast the spiral.
A deflationary spiral is basically, when a period of decreasing prices (deflation) leads to a situation whereby the economy cannot recover, which compounds over time leading to even lower prices in a vicious cycle. The root cause of this phenomenon is the reduction in the economy of the country.It is a kind of vicious circle which leads to huge amount of unemployment in a country and hence has a devastating effect on the economy.
Deflationary spiral would also result on account of global economic slowdown. In addition to weak domestic demand, even weak global demand causes a steady pile of supplies. The exports are bleak in such a scenario which also impacts the trade. Unemployment woes continue to rise due to low labour requirement. The financial burden rises on government due to decreased income. This affects the country’s economy. Thus, all in all, no one is at an advantage during deflation in the long run.
Deflationary Spiral sounds like the name of a music band
But really, it is no fun. It just goes to show how things can get worse and worse in an economy that’s in recession.
Is this what happened to the US during the Global Financial Crisis? I think this is happening in Greece very recently as well…