Deflation and what it spells for India

Updated: Sep 25, 2014, 15:27 PM IST

Akrita Reyar After nearly three decades, India is experiencing deflation once again. While inflation is a measure signifying an increase in prices, deflation is just the opposite and indicates a contraction in demand or goods and services and hence a fall in prices. In inflation, the value of your money goes down. It thus follows that in deflationary mode the value of any currency increases.

So while people should, in general, be happy about the value of each Rupee going up, the situation is fraught with problems. For one, deflation is historically associated with periods of economic slowdown or depression. Second, when the economy is experiencing negative inflation there is always the expectation that prices will fall further and so consumers prefer to postpone purchases leading to a further fall in aggregate demand of goods and services, which hits industry in a way that creates idle capacity and in turn leads to losses and job cuts, which further enhances the negative sentiment and we find ourselves in a situation called deflationary spiral. In addition there is a fear that the economy may fall into a liquidity trap. What happens in this case is that the government tries to stimulate the economy by initiating interest rate cuts. However if this fails to spur the economy to a full employment point, the Central government keeps pushing down rates till it reaches point zero. After this the government can’t do anything and so you have a situation where your saving or securities are not earning any interest on them but the increased money supply fails to create additional demand. The successive rate cuts also work inversely in a way that it prevents the government from stabilizing its monetary policy. The reduction of interest rates has different effects in closed and open economies. In a country that is heavily controlled by the government, the interest rate cuts don’t necessarily have a huge stimulating impact. Reason being that on zero interest rates, returns on government securities are also nil and can even be in the negative on short term investments. On the other hand, in economies that face less interference from the government, the effect could be of carry trade(where investors borrow cheaper currencies and lend more valuable ones) and devalues currency which makes imports more expensive without necessarily increasing the volume of exports. There is also a perceived positive side to deflation. It improves the value of money in a way that benefits common man and especially the poor by brining essential commodities like food, clothing etc within their reach more easily. This improves their standard of living despite the economy being in recession. But more often than not protracted deflation has historically caused much hardship. For example the rich businessmen during the Industrial revolution of the 19th Century benefited immensely from increased efficiencies due to cost cuts, but it was the deprived workers who had to suffer from recession Countering deflation Traditionally it was believed that deflation had a self-rectifying mechanism. It seemed obvious that when prices fell, demand would rise and the economic system would balance out without external intervention. However this view was challenged by Keynesian economists in the 1930s who felt that some outside intervention was required to ease out the situation. This would normally come from the government by the way of interest rate cuts as mentioned above or increased government spending or through tax cuts. This view remained in vogue till as far as the 1990s when all interventionist methods adopted by the government failed to have an impact in the Japanese economic model. The same proved true for the US in years 2000-02. The concern now is that monetary policies may cause a debt deflation crisis. This means that the collateral used to secure a loan decreases in value and could even lead to a restructuring of the loan agreement. It would be a situation in which lower interest rates will only provide temporary respite and be no concrete solution. The situation in India Indian economy has slipped into deflation for the first time in over 30 years, the last time being in March 1978. The question that immediately arises in one’s mind is whether deflation brings with it all the negatives associated with it and also whether it is an indication of an economy perilously close to recession. Facts however paint a different picture than the expected outcomes and indicators. For one, the falling wholesale prices are not accompanied by contracting demands. This itself is an assurance that the economy is still healthy. Ashok Chawla, a Finance Ministry top official, assuages fears saying the price drop did not signify deterioration in India`s overall economic conditions, and would not lead to any shift in economic policy. "These numbers do not reflect any contraction of demand," he said. "In fact, we are doing well and the country is on the path of improved economic performance." Meanwhile a study done by Citigroup indicates that the declining price levels are largely statistical and caused by the sharply lower fuel prices and that inflationary pressures remained. In fact the economy is predicted to be back to its usual inflationary mode by December. "You will see negative numbers for the following weeks, but by year-end we do expect inflation to go back to around 4 per cent," says Rohini Malkani of Citigroup. Reserve Bank of India Governor D Subbarao feels there is no risk of deflation as India doesn’t suffer from demand constraints. He added that there also are several other indicators to monitor inflation and not just the wholesale price index. And some of these other measures show that prices of food and primary articles are still high. The RBI Governor said it was important for stimulus plans to work through fully and that they have had some effect on parts of the economy, such as steel, cement, two-wheelers, cars, cargo and freight traffic. About the right course of action, it has been mentioned above that the Citigroup report pinned blame on fuel prices for deflation. The government recognized this fact and was also tempted to hike fuel prices not just to combat deflation but because international crude prices have been inching up. The lesson for consumer then seems to be: Shelling out more for petro products was only on expected lines.

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