Financial Literacy: Deflation: When an Economy Implodes on Itself

As I have discussed in other posts, every good, service, and commodity has a value, and that value is denominated, or measured in terms of the national currency; in our case the value of anything is measured in dollars.  (Go to Billionaires Who Can’t Afford a Loaf of Bread  Even money has a value that fluctuates, and there are events that trigger changes in the value of money.  Money is measured by it’s purchasing power, and economists spell this with capital letters Purchasing Power (PP).  Money by itself has no value; it is only a symbol and a medium of exchange, so the real question is how much of anything can you exchange a dollar for??  I have covered what happens during a period of inflation, and the costs of everything as measured in dollars goes up, which means the value of the dollar (or its purchasing power) goes down.  People think they are better off with rising wages, but factoring in the decreased ability of those wages to purchase, they are actually worse off. 

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Deflation is the opposite.  During a period of deflation there is not enough money in circulation to buy the goods and services available.  Ironically one of the reasons for this could be that the population is nervous about their financial future and they start saving their money instead of spending it.  The money is there, but it is not in circulation, because people (and companies) are not in a mood to take risks.  When people aren’t buying, companies lay off employees, which contributes to the overall feeling of insecurity.  Because people aren’t buying, companies slow down manufacturing, and the amount of product they keep in inventory in their warehouse and distribution centers goes down and is not replaced.  In order to improve sales, they lower prices.  Since wages are the price of labor, that means the wages gradually go down also.  That means there is less money to spend, and the cycle feeds on itself.  In this way an entire economy can implode on itself.

Something needs to be said about the effects of inflation and deflation on debt at this point.  During times of inflation, prices (including wages, the price of labor) are going up; the purchasing power of those dollars is going down.  If you owe fixed-interest debt during a period of inflation, your wages will inflate with the rest of the economy, but your debt, which is fixed by contract with your creditor, remains the same.  That means you will be paying your debt back with cheap dollars, dollars that are worth less than they were when you incurred the debt.  During inflation, debt can be your friend, and the enemy of your creditor.

During deflation, however, debt is your enemy.  Your debt is once again, fixed by contract to a certain amount of dollars, but your wages, along with the rest of the economy, are deflating, or going down.  Your debt can hang you during a time of deflation.

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