deflationIf a currency with a fixed supply limit is used as the medium for a significant portion of trade, would the deflation be economically damaging?
It depends how you define inflation and deflation:
I will ignore #1 (since it doesn’t make sense in the context of your question) and assume you mean definition #2.
At first blush, the idea of falling overall prices sounds quite good. Think about the market for PCs, for example. PCs have simultaneously fallen in prices consistently for over 20 years, at the same time getting more powerful and useful. Computer companies are making good money and consumers are getting great products. Win-win.
The danger of falling prices has to do with why prices are falling. If, as in the case of the PC, prices have fallen slowly over time due to increases in capital concentration and worker productivity, then falling prices are a good thing! We can buy more and better goods with the same amount of money.
If, on the other hand, prices fall because the economy is growing but the supply of money is fixed, then this may pose problems. There are a few problems commonly called out by critics of deflation, so I’ll try to name a few and then offer my opinion:
A. Deflation encourages savings, not borrowing.
This criticism is that the deflation rewards savings and makes borrowing money more costly, so it will shift the balance between savings and lending, perhaps to the detriment of society.
I disagree with this. Savings and borrowing must occur in equal amounts. I cannot borrow money unless I can find somebody else who has savings to lend to me. The interest rate is the “price” associated with saving and borrowing money, and this price should naturally float to a place where the supply of savings is roughly equal to the demand for borrowing.
B. Price deflation leads to wage deflation/higher unemployment.
The criticism here is that lower prices mean lower corporate profits, therefore companies will cut wages or fire workers to stay profitable.
I disagree because the increase in capital investment and worker productivity each year acts against wage deflation. In other words, prices may be lower, but each worker is also more productive. This effect of productivity may completely offset the decrease in prices.
If the effect of increasing productivity is not large enough to offset the decrease in prices, then we still don’t have to accept high unemployment. Instead, we might accept that wages may decrease slowly in times of low economic growth. In the US, we expect salaries to inch higher every year, but this expectation is largely based on 100 years of central banking that promotes low-and-slow inflation. I believe that this is a mindset that could be changed slowly if necessary.
C. Price deflation encourages buyers to defer purchases.
The criticism here is that if consumers believe deflation is a trend, then they expect that the value of a car (for example) will be less next year than it is this year, and therefore they will wait to purchase a new car.
Again I disagree. People will buy things they need no matter what, such as food, clothing and shelter. Furthermore, there is always a premium to having something now versus in the future, so even if you think a car may be a little cheaper several years from now, you’re willing to pay a bit more to have it right now.
Look at the PC example. Prices have dropped steadily for over 2 decades. This is a fact known widely among all PC consumers, and yet consumers continue to buy new computers, knowing full well that next years computers will be a little cheaper and a little more powerful.
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