Definition of Deflation & Effects of Deflation
Definition of Deflation
Deflation can be defined as the decrease in the overall price level of goods and services. Deflation occurs when the inflation rate falls below 0%. Inflation reduces the value of currency over time, but sudden deflation increases it. It is a situation where there are drops in prices in the consumer price index is where the price of the basket of goods is actually lower than it was the period before.
Effects of deflation
Short Run Effects of Deflation
How do businesses react or be affected by this concept known as deflation? It certainly sounds like a good thing, and for consumers and a fall in the economy’s level of prices sounds incredibly attractive.
For businesses, deflation is a short-term that may indeed have some benefits to it. Because if prices are falling in the economy, then it makes sense that the firm’s costs may also be falling.
Whether that be their production costs and the costs of their raw materials or the cost of their bills and their outgoings and the energy that they have to source in the short term if those prices are falling but a firm can keep its selling price at the same level, and it may actually be beneficial for the firm.
And it may allow them to experience a short boost in profit. This is because when the costs are dwindling, and they keep their prices the same, then it made me that they are able to preserve a greater profit margin on the products that they sell.
When the demand for their products continues to be constant; then, it means that in financial terms, the firm might experience just a small bump in profits.
Long-Run Impact of Deflation
The thing is that phenomenon is not likely to play out if deflation is more sustained, and if it takes place in the long term because if prices continue to fall, it can impact consumers.
That’s actually quite negative for firms because as prices continue to fall, consumers start to think about whether it is actually the right time for them to be purchasing goods and services or be better delaying their consumption?
Decisions may be buying something next month rather than this month or in six months rather than now because they are envisaging that prices will continue to fall.
Why buy something new when you know that if you just hold on, it will be cheaper in the future? That is fine from a consumer’s point of view.
But for firms, that means that they’re missing out on sales. It means they’re going to start to experience falling levels of demand as more and more consumers are delaying purchasing decisions until some undefined point in the future.
And firms will have to bear the brunt of these falling levels of demand and make decisions and craft strategies accordingly.
When the demands start to fall, if their sales start to fall, it might mean that firms need to start reducing their own prices perhaps more rapidly to try and appear so attractive to consumers that they make their purchasing decisions.
But that’s going to mean that their own profit margins are going to be squeezed. It means they might preserve their sales volume, that sales of value in the revenue they’re making from their sales are going to start to suffer.
It also means that the firm might have to start making some more peripheral decisions about its costs as well.
So, if deflation is sustained and prices continue to fall across the economy, the firm will have to look at some of its own costs, particularly its labor costs.
And cannot justify giving employees pay arises at a time when prices across the economy are tumbling, and so the cost of living is falling. Again, that can bring firms into conflict with their workforces as they start to take on workers on contracts that are not as generous perhaps as they once were, as they start to decline their workforce, pay rises, and start to freeze pay levels for staff.
So that can create kind of HR issues that the firm might have to absorb and have to try and combat through other HR strategies.
And the way it affects consumers, particularly the long term, imagine prices might be tumbling inside the economy, might mean that workers you’re experiencing price freezes.
Some unfortunate workers might find that because some firms are experiencing foreign demand, there are suffering redundancies that might be unemployment that might be people left without jobs. All of these things a recurring; the one thing that’s not falling is consumers’ debt levels.
If consumers have taken out loans and mortgages, then prices inside the economy might be falling on their wage levels might be static, or if they have to look for new jobs, they might have to take on work being paid less than they were before.
So, workers might be experiencing falling incomes or frozen income levels. But it may be that the debt levels that they’ve got are still preserved at the same high level.
These payments aren’t coming down, but the worker’s incomes are being squeezed, and their wages a tumbling. So that’s going to affect their purchasing decisions.
They will begin to start rationalizing.
- What do they need to buy?
- We make cutbacks.
- Where can we cut expenditures?
- Where can we reduce out unnecessary bills?
- Can we trade one good and service for an inferior, cheaper version to carry on surviving to carry on living
All of this is going to form a big melting pot for firms is going to impact on;
- Sales volume
- Ability to experience economies of scale.
- Revenue figures are going to be infected, dividends they give on to shareholders
While deflation of price level fallings is good in the short term for firms, deflation can be more damaging for businesses in the long run.
Deflation, in the long term, can have some pretty severe consequences for the economy. Fortunately, we don’t find deflation occurring very often in an economy.
The concept of deflation and its impact on businesses really depends on how long or sustained these reductions in prices.