Deflationary Spirals

November 15th, 2013
inflation, money
The standard economic view is that deflation is bad because it leads to more deflation. The idea is that if you own a widget factory and the price you can get for your widgets falls you will decrease the number you make. You lay off some employees, don't buy new machines, and try to stay profitable. If this happens through enough of the economy at once then everyone's incomes go down, they can't afford to spend so much for a new widget, and the price you can get falls further. Similarly, because people expect the value of money to rise they hold onto it instead of spending it, which amplifies this process and leads to even higher values of money.

There are two things I don't understand about this, however:

  • This whole spiral is kicked off by the widget manufacturer responding to lower prices by decreasing how many widgets they make. But if everyone knows prices are only going down because of deflation then the signal for the manufacturer to pay attention to isn't "are prices falling?" but "are prices falling faster than deflation?" or "are widget prices falling faster than the cost to manufacture them?" Manufacturers already have to be careful not to mistake inflation for rising demand.
  • If everyone knows that a dollar today will be worth twice as much in a year (deflation) then why doesn't the dollar become worth that much now? In general you don't see values rise continuously because people anticipate and price in future changes. (efficient market hypothesis)

(Normally deflation isn't much of an issue because the government can print more money at any time and push us back to inflation. If bitcoin were to become the primary currency, however, the government wouldn't have that option. I'm trying to understand how dangerous that is.)

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