The mechanics of deflation- increase in demand for holding cash

August 8th, 2007

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Last time, in Cause of inflation: Shanghai bubble case study, we wrote about the true nature of inflation, which is defined by the the Austrian School of economic thought as the rise in the supply of money (monetary inflation, i.e. ?printing? of money). The outcome of monetary inflation is price inflation, which is the general increase in pricel levels. As Ludwig von Mises said in Inflation: An Unworkable Fiscal Policy,

If the housewife who needs a new frying pan reasons: “Now prices are too high; I will postpone the purchase until they drop again,” inflation can still fulfill its fiscal purpose. As long as people share this view, they increase their cash holdings and bank balances, and a part of the newly created money is absorbed by these additional cash holdings and bank balances; prices on the market do not rise in proportion to the inflation.

But then?sooner or later?comes a turning point. The housewife discovers that the government expects to go on inflating and that consequently prices will continue to rise more and more. Then she reasons: “I do not need a new frying pan today; I shall only need one next year. But I had better buy it now because next year the price will be much higher.” If this insight spreads, inflation is done for, Then all people rush to buy. Everybody is anxious to reduce his holding of cash because he does not want to be hurt by the drop in the monetary unit’s purchasing power. The phenomenon then appears which, in Europe was called the “flight into real values.” People rush to exchange their depreciating paper money for something tangible, something real. The knell sounds of the currency system involved.

Today, we will talk about the converse?deflation.

Deflation happens when liquidity dries up. This can happen in a period of severe economic pessimism when the apprehension of the future drives people to increase their holdings of cash for the sake of peace of mind. When that happens, the quantity of money in circulation decreases, which means there are fewer money chasing after a given amount of goods and services. Consequently, prices have to decrease to accommodate for the decreased supply of money in circulation.

When deflation mentality gets a stranglehold on to the minds of the people, no one will dare to borrow money out of fear. Also, when prices are falling, the money that one borrows will be worth more by the time the debt is due. There is no point in spending money because if one waits a little longer, prices will fall further. Central bankers can print as much money as they can, but in such a deflationary environment, no one will want to borrow them.

This was what happened to Japan. Despite their central bank cutting interest rates to zero and their government engaging in an orgy of infrastructure spending, recovery was not in sight except until very recently.

If you are wondering why we are talking about deflation, please take a read at our earlier article, Inflation or deflation first?.