I am pretty confused with this concept. Since deflation is a result of decreasing prices, it means that the demand for goods and services rise therefore stimulating more spending. But on the other hand it is also a matter of fact that it encourages people to save (see potential in the increasing value of money over time).


2 Answers 2


Think about the permanent income hypothesis. People's spending is dependent not just on present income, but also the future stream of income. A deflation usually indicates a recession. The central bank is trying to optimize monetary policy subject to a short run Phillip's curve.

$$\min_{u, \pi} V(u, \pi) = -(u^2 + \pi^2)$$ such that $$u = u^* + k(\pi^e - \pi)$$

where $u$ is unemployment, $u^*$ is the natural rate of unemployment, $k$ is the sensitivity of the tradeoff, and $\pi^e$ is the market expectation of inflation.

If you find a Nash equilibrium for this game with credibility in the model, then the Federal Reserve will want to target a constant steady rate of inflation. If the economy falls into recession, they will in return try to raise inflation, because in the short run it serves as a tradeoff with unemployment, so though the Fed is causing more inflation, hopefully they will stop too many people from losing jobs (note the loss function for the Fed in this case is convex). If the Fed tries out monetary policy and still sees deflation, then you can tell the recession is pretty rough, if that makes sense.

So even though the price of goods falls, wages on average will fall, and production will fall. So demand in the economy will fall. Those who do still have a good job are doing better on average than those who become unemployed, and they might dissave in periods where expected income in this recessionary period might be lower than future periods where the economy is doing well, but in reality, most people will be liquidity constrained and will be saving what little they can while drastically cutting back on spending. Usually. There are exceptions (think of payday loans).


We need to get cause and effect clear.

It is incorrect that "deflation is a result of decreasing prices".

In fact, the price level at a given time is determined solely by the preferences of the people (to the extent the society is cooperative, i.e., not coercive.) At a higher price level than the actual one at a given time, there would be more suppliers who prefer money to goods than there were buyers who preferred that amount of goods to that amount of money. The market sets the price to the level where supply equals demand. For the moment we are assuming for simplicity that people don't want to save, only consume.

What causes deflation? Since deflation is a decline in the price level, from the above we see that it must be caused by a change in human preferences. The (aggregate) preference for goods and services relative to money must have decreased. Last year I was willing to produce a pumpkin and trade it for 2.00, but not 1.90. This year I will produce and sell it for 1.90.

So, the correct cause-and-effect relationship is: deflation is caused by a change in human preferences for money relative to real wealth.

It is also incorrect to say that deflation causes changes in spending ( quantity supplied, which equals the quantity purchased.) Both the aggregate quantity level and the price level are determined by human preferences: the quantity and price both adjust to the level at which the market is cleared, where supply = demand at that price.

Likewise, deflation (price level) does not cause the level of saving. Saving level is the result of the aggregate of human preferences, in this case the preference for current goods over future goods.


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