What is deflation and how can it be prevented?

While I haven't polled every economist who has written an article on deflation this should give you a good idea of what the general consensus on the subject. A psychological factor that has been overlooked is how many workers look at their wages in nominal terms. The problem with deflation is that the forces causing prices in general to drop should cause wages to drop as well. Wages, however, tend to be rather "sticky" in the downward direction. If prices rise 3% and you give your employees a 3% raise, they're roughly as well off as they were before. This is equivalent to the situation where prices drop 2% and you cut the pay of your employees by 2%. However, if employees are looking at their wages in nominal terms, they'll be much happier with a 3% raise than a 2% pay cut. A low level of inflation makes it easier to adjust wages in an industry whereas deflation causes rigidities in the labor market. These rigidities lead to an inefficient level of labor usage and slower economic growth.

Now we've seen some of the reasons why deflation is undesirable, we must ask ourselves: "What can be done about deflation?" Of the four factors listed, the easiest one to control is number 1 "The supply of money". By increasing the money supply, we can cause the inflation rate to rise, so we can avoid deflation.

In order to understand how this works, we first need a definition of the money supply. The money supply is more than just the dollar bills in your wallet and the coins in your pocket. Economist Anna J. Schwartz defines the money supply as follows:

"The U.S. money supply comprises currency -- dollar bills and coins issues by the Federal Reserve System and the Treasury -- and various kinds of deposits held by the public at commercial banks and other depository institutions such as savings and loans and credit unions."

There are three broad measures economists use when looking at the money supply:

"M1, a narrow measure of money's function as a medium of exchange; M2, a broader measure that also reflects money's function as a store of value; and M3, a still broader measure that covers items that many regard as close substitutes of money."

The Federal Reserve has several options at its disposal in order to influence the money supply and thereby raise or lower the inflation rate. The most common way the Federal Reserve changes the inflation rate is by changing the interest rate. The Fed influences interest rates causes the supply of money to change. Suppose the Fed wishes to lower the interest rate. It can do this by buying government securities in exchange for money. By buying up securities on the market, the supply of those securities goes down. This causes the price of those securities to go up and the interest rate to decline. The relationship between the price of a security and interest rates is explained on the third page of my article The Dividend Tax Cut and Interest Rates. When the Fed wants to lower interest rates, it buys a security, and by doing so it injects money into the system because it gives the holder of the bond money in exchange for that security. So the Federal Reserve can increase the money supply by lowering interest rates through buying securities and decrease the money supply by raising the interest rates by selling securities.

Influencing interest rates is a commonly used method of reducing inflation or avoiding deflation. Gongloff at CNN Money sites a Federal Reserve study that says "Japan's deflation could have been dodged, for example, if the Bank of Japan (BOJ) had only cut interest rates by 2 more percentage points between 1991 and 1995." Colin Asher points out that sometimes that if interest rates are too low, this method of controlling deflation is no longer an option, as currently in Japan where interest rates are practically zero. Changing interest rates in some circumstances is an effective way of controling deflation through controlling the money supply.

Be sure to continue to page 4