The U.S. Consumer Price Index fell by 1.5% in August, marking the sixth consecutive monthly decline, writes economist Frank Shostak. Most experts believe that falling prices signals problems for the economy because consumers will postpone buying goods, expecting prices to fall even lower.
Many economists define deflation as a fall in prices, rather than a fall in the money supply. Deflation, therefore, becomes the enemy against which an inflationary monetary policy is directed. With a sufficient increase in the supply of money, prices will rise and people will be more inclined to buy now rather than later when prices will be even higher.
But is this reasoning realistic? Why should falling prices discourage consumption? People must support their lives in the present and so will buy in the present. Even in our inflationary world some prices have fallen deeply while consumers have been buying. As Shostak notes:
From December 1997 to August 2009, the prices of personal computers have fallen by 93%. Did this fall in prices cause people to postpone buying personal computers? On the contrary, since December 1997 consumer outlays on personal computers have increased massively. These outlays stood at $83.2 billion in August 2009 as compared to $3.4 billion in December 1997.
Furthermore, most experts claim an inflation rate of around 2% is good for economic growth, while these same experts would say a rate of 10% is bad. What is the logic here? The higher the rate of inflation, the more pressure consumers will feel to buy now rather than later. So why would 10% be worse than 2%?
Shostak suggests the problem lies in the understanding of inflation and deflation. Inflation is an increase in the money supply, not a rise in prices, while deflation is a decrease in the money supply, not a fall in prices. Generally, though, an increase in the supply of money will produce a rise in prices, while a fall in its supply will lower prices.
Whether prices fall on account of the liquidation of nonproductive activities or on account of real-wealth expansion, it is always good news. In the first case, it indicates that more funding is now available for wealth generation, while in the second case, it indicates that more wealth is actually being generated.