Should Prices Always Rise?

The modern economy is obsessed with rising prices. An era of falling prices is called deflation. It is almost always considered to be bad news from an economic point of view. The commonly held viewpoint is that falling prices create negative sentiments and ultimately to a recession. Falling prices have been given the name “deflation”. These falling prices immediately send alarm bells ringing across the economy. The modern economy is hooked on inflation! The common belief is that deflation is a negative phenomenon. However, this does not have to be the case.

In fact, the opposite is true. If we look at the economy of any nation under the gold standard, deflation was considered to be the norm. It is for this reason that America witnessed a mild deflation of about 1.75% per annum in the 1800’s and the early 1900’s. This is also the period where the American economy grew rapidly. The per capita income of the average person in the United States went up several times during this period.

It turns out that deflation is not as economically devastating as it is made out to be. In this article, we will list down some of the common misconceptions related to deflation and its effect on the economy.

Would A Deflationary Economy Work?

People tend to look up to the economy in a very intuitive way. If the number is rising, it must be good. If not, it is probably bad. However, economies cannot be oversimplified in this manner. They need to be understood for what they are.

A deflationary economy is not bad for the people. In fact, it is the result of avoiding conspicuous consumption. When an economy invests a lot of its money into capital formation, productivity increases. As a result of this productivity, the cost of manufacturing goes down. The price of goods, therefore, becomes cheaper. People can buy more of the product even if their income remains the same. This is an increase in their standard of living. In this scenario, even though the nominal wages of the worker remain the same, their real wages rise making their lives better and easier.

Myth #1: Decreasing Prices Delay Consumption

The most common myth related to deflation is that it creates a negative sentiment. This negative sentiment then encourages customers to defer their purchases. Deferring purchases is bad for the economy as it reduces the aggregate demand and consumer spending. However, this theory is not true. Consider the fact that prices of computers have been falling all over the past two decades. Every year better computers are available at a cheaper price. However, every year consumers who have to make their purchases continue to do so. This is true of mobile phones and all other electronics as well. The expected future price only influences the purchase decision of investments and speculative products. Goods that are required for consumption purposes are purchased even though there is a likelihood of a moderate price decline in the future.

Myth #2: Price Decreases Will Not Be Passed On To the Consumer

The second most common myth harbored by many economists is that price rise will be absorbed by the manufacturers. After all, why would any manufacturer want to earn fewer profits? If they can already sell to customers at a given price, there is no reason why they should decrease their prices further. The reality is that decreasing prices is not really an option. It is not something that manufacturers decide to do. Rather, this is something that the manufacturers are compelled to do because of competitive pressures. Once again, the electronics industry can be considered to be an example. The manufacturers that have not dropped their prices have become extinct.

Myth #3: Deflation Leads to Recession

Recession is defined as the fall in the economic output of a country. The economic output is a combination of prices and the quantity produced. If the quantity increases by a greater percentage than the decline in prices, then the economy will not go into recession. Once again the case of the electronics industry comes in handy. The prices of these products have dropped year on year. However, since the quantity of these products sold has increased the industry has not gone into decline.

Myth #4: Deflation Leads to Falling Profits

It is true that deflation leads to a fall in prices. However, a fall in prices does not necessarily mean a fall in profits. This is because input and output prices fall. Hence if the price of finished products falls, so does the price of raw materials. The cost of labor remains stagnant even though labor productivity has increased. Hence, deflation does not lead to falling profits. Also, it is mathematically impossible for the prices to keep on rising forever without causing runaway inflation.

Hence deflation can be considered to be a bogeyman. It is used to scare away people who demand price rationalization and less inflation. However, in reality, it is not necessarily a bad outcome. If we change our way of thinking, deflation might start to look like a positive scenario as well.