Deflation is a decrease in price levels, which can be dangerous for the economy. It can occur due to a higher demand for money, a higher supply of goods, a lower supply of money, or a lower demand for goods. The national bank can combat deflation by increasing the money supply through interest rates. However, stability is key, and not all price reductions are the result of deflation causing an economic crisis.
Deflation is a decrease in price levels. It is the opposite of inflation in the sense that inflation generally leads to rising prices. However, while consumers may accept a decline in price levels in one sense, deflation can be a very dangerous situation. Economies, in general, do not like severe inflation or deflation, and both can be volatile situations full of worries.
Just as inflation makes money less valuable, deflation makes money more valuable. As such, deflation can occur at times when interest rates are high and money lock-up is low, thus creating a situation where there is a reduction in credit. In fact, there are four reasons why deflation can occur. Either there is a higher demand for money, a higher supply of goods, a lower supply of money, or a lower demand for goods.
The most common way to combat the fear of deflation is for the national bank to increase the money supply. In the United States, this job falls to the Federal Reserve. Most other countries have an institution that performs similar functions. The Federal Reserve (Fed) monitors situations related to the money supply, both in terms of deflation and inflation, and seeks to act accordingly.
However, increasing the money supply does not simply mean opening the vaults and allowing anyone to take it. In such a situation, the problem would quickly turn from deflation to inflation. Therefore, the Fed achieves this through interest rates. In a period of deflation, the Federal Reserve lowers interest rates, thus encouraging banks to borrow more and lend them at lower rates.
Small changes in Fed interest rates can usually create big waves within the financial community. These will likely be felt both nationally and internationally. Because of this power, the Fed typically only cuts rates a fraction of a percentage point at a time and then waits to see what effect that will have before deciding on further rate hikes or cuts. The goal is always to find a balance that helps the economy and decreases volatility. In financial matters, stability is the key.
It should also be noted that not all price reductions are the result of deflation causing an economic crisis. Companies may always be looking for ways to find efficiencies in production. The consumer often sees these efficiencies in the form of lower price levels. However, production efficiencies are usually identifiable and are not easily mistaken by professional analysts. Often these efficiencies may apply to one type of product or even within a certain company, not to the economy as a whole. If more than one sector of the economy is affected by falling prices, deflation would be the likely culprit.
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