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Tuesday, January 11, 2011

Causes of Deflation

Causes of Deflation

Deflation is nothing but a fall in the general price level. In order to understand the circumstances under which Deflation occurs and affects an economic condition, one needs to go through the causes of Deflation. Causes of Deflation:

Capitalism characterized by sufficient existence of competition, is regarded as one of the factors responsible for the emergence of Deflation. In this case, with the improvement in the capital stocks, competition increases million fold. Escalation in the total number of competitors boosts up the supply of goods, indicating that the prices must decrease in order to stabilize the demand, thereby bringing in Deflation. Capitalism also brings in innovation and efficiency, which also contributes towards the initiation of Deflation.

In an economy based on credit, a decrease in money supply results in remarkably less lending trend, followed by a sharp decline in the money supply. As a result, there occurs a sharp reduction in the demand for goods. A decline in the demand is followed by a decline in the prices, owing to the development of a condition called the supply glut. Gradually, this assumes the form of a deflationary spiral, where the prices go down below the costs of financing production.

With the advent of deflationary spiral in an economy, the commercial sector of the country stops incurring profits, despite lowering the prices of their finished products. Ultimately, a situation arises where this commercial sector is forced to become liquidated. In order to prevent or slacken down the deflationary spiral, it is necessary for the banks to avoid the collection of non-performing loans.

According to the monetarist viewpoint, Deflation occurs when there is a decrease in the velocity of money, and/or in the amount of monetary supply per person. Deflation helps the economy grow and develop at a rapid pace, even faster than the creation of hard money.
To sum up, deflation arises due to the following conditions stated below:

Decrease in the money supply
Increase in the supply of goods
Fall in the demand for goods
Escalation in the demand for money

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