Deflation occurs when there is not enough currency in circulation to meet the needs of the economy. Here again, the classical definition focuses on falling prices rather than an insufficient currency stock, but deflation is primarily a monetary phenomenon.
It is the economic version of anemia: too little blood is reaching the body. Each unit of the currency goes up in value relative to the goods and services available, but because the stock of currency isn’t growing fast enough, it starves the economy of investment capital. There isn’t enough money to build out existing business, to create new ones, or to hire new workers. (This is in part what happened during the Great Depression of the 1930’s.) Inventories shrink, but new goods aren’t being produced due to the lack of investment capital. Eventually the economy grinds to a halt as production withers away.
Specie currencies are more prone to deflation than fiat currencies for the simple reason that fiat currencies are not based on scarce (and thus valuable) resources like gold, silver, or what have you. There’s only so much gold and silver to go around, and sometimes the supply of bullion can be interrupted for long periods. (Sometimes this is even done deliberately by rival nations or speculators.) Also, because the value of gold and silver is set outside the control of government or authority issuing the currency, it limits the kinds of monetary policy the sovereign can conduct, especially during times of crisis.
Monty, “Inflation, Deflation, and Monetary Policy”, Ace of Spades HQ, 2014-07-11.
May 25, 2015
QotD: Deflation
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