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Business News/ Money / Calculators/  DYK| Falling prices are not always good for the economy
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DYK| Falling prices are not always good for the economy

If economies face deflationary conditions, it will be extremely difficult to pull them back

Ramesh PathaniaPremium
Ramesh Pathania

Global commodity prices, including of crude oil, have corrected significantly and this augurs well for India, which has been struggling with high inflation for years. The fall in commodity prices is helping the overall policy stance of containing prices. While India is celebrating the disinflationary process, the decline in general price level, or slower than warranted increase in prices, is creating a fair amount of economic uncertainty in other parts of the world.

For example, Bank of Japan increased the quantum of its quantitative easing last week to push prices, among other things. In its statement, the Japanese central bank noted: “…if the current downward pressure on prices remains, albeit in the short term, there is a risk that conversion of deflationary mindset, which has so far been progressing steadily, might be delayed. To pre-empt manifestation of such risk and to maintain the improving momentum of expectation formation, the Bank judged it appropriate to expand the quantitative and qualitative monetary easing."

Bank of Japan is targeting Consumer Price Index-based inflation at 2% while the actual number (excluding fresh food) is at around 1.25%.

Japan is not the only country worried about a slow pace of price rise. Euro zone, with inflation at 0.3%, too, is facing a risk of deflation.

Problem with falling prices

Prices in several countries, especially in the developed world, are rising at a slower pace than desired, while some are facing a risk of deflation, where prices actually begin to decline. This is despite interest rates (read cost of money) being close to zero. Therefore, if these economies face deflationary conditions, a state of decline in general price level, it will be extremely difficult to pull them back.

The lower than desired level of inflation is an indication of weak demand and weaker economic activity. But if prices begin to decline, economic activity will suffer even more. For example, consumers will postpone spending as things are likely to get cheaper at a later date. Firms will not invest in capacity expansion because of falling demand and lower expected returns on investment due to falling prices. Indebted companies and governments will cut investment and expenditure to repay debt, which will rise in real terms because of the falling revenue.

Overall, the economic activity will be hit and the economy will go into a downward spiral, affecting the level of output, income, employment and standard of living. Therefore, it is important for policymakers to avoid such a situation.

Bank of Japan has increased its firepower and has decided to print more money to push up prices and economic activity. The European Central Bank could be next in line.

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Published: 05 Nov 2014, 06:18 PM IST
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