money-supply, gold, deflationLet’s say you have a economy with commodity money system (gold standard for instance) and the produced amount of goods (created values) increases faster than the amount of the available commodity money (amount of gold mined). This will cause deflation.
Will such deflation slow down real economic growth?
Also, was the Great Deflation caused by this effect? Do you know of any other example when the discrepancy between the amount of money and the amount of created values caused deflation or slowed down economic growth?
###Credit free economy ### In an imaginary economy that prohibits credit I don’t think that an instantaneous deflation would reduce growth. Deflationary expectations might though, because consumers will attempt to defer purchases to when they are cheaper.
###Effect of debt on recession### Credit amplifies the effect of deflation on recession. In a real economy where assets (such as houses and factories) have been purchased on credit, falling wages will cause defaults. Banks then call in loans, which has two effects:
The resulting wage and price reductions feed back into decline in economic activity.
###Money supply and growth### Total money supply is the sum of credit and base money, and credit is much larger than base money. Credit enabled investment in productive enterprise increases growth sustainably. But credit issued for consumption can increase growth in the short term only.
###Controversy### I should point out that the analysis above is not the only view and might not even be a majority view. Here is a good starting point for further reading http://en.wikipedia.org/wiki/Debt_deflation
In order for the economy to function “normally” there must be enough money circulating at a given velocity for the money supply to satisfy all transactions. If the value of money is growing, people will tend to hold on to it thus reducing the amount available for “normal” circulation and reducing the number of transactions which can be undertaken. This would reduce growth if the amount of transactions taken is lower than the amount which would satisfy supply and demand. Access to credit can alleviate this as people can buy on money they don’t have on hand.
Eventually in a credit system, access to credit becomes the constraint and so reductions in access to credit, due to various market shocks, even if temporary, can constrain the amount of money available for the “normal” flow of money and reduce the number of transactions despite otherwise steady supply and demand.
Japan has had deflation and varying growth for the last decade. You could look into that case for a more recent example than the Great Deflation.
In order to try to answer this question it may be useful to recall what the functions of money are.
The first function of money is to facilitate trade. Imagine a coal miner who gets paid with coal. Whenever he wants to buy anything, first he must find a person that has the item he wants and this very same person has to want coal in order for the transaction to be carried out. (This is called the problem of double coincidence of wants.) Because the miner is likely to have a hard time finding people to trade with, he will work less and produce less coal than he otherwise would if he was paid with money. So, if money becomes very scarce, it could get to a point where trade becomes difficult and production levels fall. Something like this happened after World War II, when most European countries had run out of foreign reserves and that prevented them from engaging in international trade and the economy from recovering.
Second, money is a store of value. Deflation means that prices go down or, what is the same, that every unit of money can buy more as time goes by. Therefore people may refrain from spending, in the hope that they will be able to spend more in the future, because the purchasing power of money increases with time. So, it is conceivable that deflation can reduce spending temporarily, although personally I haven’t got concrete evidence of this happening.
Third, money is a unit of account. This means that prices are expressed in units of money. If the amount of money relative to the amount of goods and services varies, then all prices have to be adjusted accordingly. Now, some economists say that not all prices adjust at the same speed (the theory of “sticky prices”). For instance, we know that the price of oil changes daily, whereas wages adjust at a much slower rate. If this happens, it can make resources to be re-allocated according to the new relative prices. Again, I can’t think of any concrete example where this effect has been measured.
I have found this on Wikipedia, however I haven't read the book:
The gold standard acts as a limit on economic growth. “As an economy’s productive capacity grows, then so should its money supply. Because a gold standard requires that money be backed in the metal, then the scarcity of the metal constrains the ability of the economy to produce more capital and grow.”
Mayer, David A. The Everything Economics Book: From theory to practice, your complete guide to understanding economics today (Everything Series) ISBN 978-1440506024. 2010. Pgs. 33-34.
Will such deflation slow down real economic growth?
No. Such deflation is what economic growth is. It is one way to define economic growth (if you hold everything else constant). Economic growth is when the economy can produce more output with the same input (due to an increase in capital goods).
If you can buy the same TV for half the price because the manufacturer is more efficient. Why would this harm the economy? It wouldn’t.
The Wikipedia article you linked to says:
[deflation] had a negative effect on businesses in established industrial economies such as Great Britain while simultaneously allowing incredible growth in the United States which was just beginning to industrialize
The part about deflation negatively effecting businesses in Britain is simply false. Producing more goods with the same inputs does not have a negative effect on business. That is ludicrous. Don’t believe everything you read. There is a lot of misinformation in economics these days.
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