Question

An article in the American Free Press quoted Professor Peter Spencer of York University in England as saying, "This printing of money 'will keep the [deflation] wolf from the door." The same article quoted Ambrose Evans- Pritchard, a writer for the London-based newspaper The Telegraph, as saying, "Deflation has ... insidious traits. It causes shoppers to hold back. Once this psychology gains a grip, it can gradually set off a self-feeding spiral that is hard to stop." a. What is price deflation? b. What does Spencer mean by the statement "This printing of money 'will keep the [deflation] wolf from the door'"? c. Why would deflation cause "shoppers to hold back," and what does Evans- Pritchard mean by saying "Once this psychology gains a grip, it can gradually set off a self-feeding spiral that is hard to stop"?

Short answer

a. Price deflation refers to a decrease in the general price level in an economy, increasing the currency's purchasing power. b. Professor Peter Spencer suggests that increasing the money supply in an economy can help lessen or avoid the damaging effects of deflation. c. Deflation can cause consumers to hold back spending in anticipation of further price decreases, triggering a self-feeding spiral where decreased spending leads to further deflation, which then encourages more postponed spending.

Step-by-step solution

Define Price Deflation

Price deflation is a decrease in the general price level of goods and services in an economy over time. When the general price level decreases, with all other things remaining constant, the purchasing power of currency increases. In other words, deflation is the negative inflation rate.

Explain the Wolf from the Door Statement

The statement by Professor Peter Spencer can be broken down as follows: the ‘printing of money’ refers to monetary policies, such as those often implemented by a central bank, that increase the supply of money in an economy. The ‘deflation wolf’ metaphorically represents the danger and damaging effects deflation can have on an economy. By saying 'keep the wolf from the door,' Spencer is suggesting that if more money is circulated in the economy (through creation or printing of money), it would help avoid or lessen the impact of deflation.

Describe the Effects of Deflation on Consumer Behavior

Deflation can cause 'shoppers to hold back' because as prices decrease, consumers may anticipate that prices will continue to fall even further. This postponing of purchases in hopes of future price decreases leads to lower demand, thereby further exacerbating the deflation. This is what Ambrose Evans-Pritchard was referring to when he mentioned a 'self-feeding spiral that is hard to stop.' Decreased spending leads to further deflation, which then encourages consumers to delay spending even more — the cycle repeats itself and can spiral out of control.

Key concepts

Price Levels

Price levels refer to the average of current prices across the entire spectrum of goods and services produced in the economy. When observing price levels, you can determine whether the economy is experiencing inflation or deflation. Inflation means price levels are increasing, which decreases the currency's purchasing power because it costs more to buy goods and services. Deflation, on the other hand, indicates decreasing price levels. When deflation occurs, every unit of currency will buy more goods and services than before. While this might sound beneficial to consumers, deflation can signal underlying economic issues and result in long-term negative consequences. Understanding how price levels change can help economists and policymakers make decisions to stabilize the economy.

Consumer Behavior

Consumer behavior changes significantly in response to deflation. When consumers notice prices are falling, they may decide to hold off on purchasing goods, expecting prices to drop even further. This tendency to delay spending can reduce overall demand for goods and services. Here’s why this happens:

• People think they might get goods cheaper in the future.
• Uncertainty about the economy leads to cautious spending.
• Consumers may anticipate lower future incomes and try to save money.

This shift in behavior can have a large impact on the economy. As people spend less, companies earn less revenue, which might lead them to reduce salaries or lay off workers. This, in turn, affects consumer confidence even more, causing further decreases in spending. It's important to understand these behaviors to help implement strategies that combat deflationary pressures.

Monetary Policy

Monetary policy is a tool used by a country's central bank to manage the economy's money supply and interest rates. During deflationary periods, monetary policy often involves increasing the money supply – commonly referred to as 'printing money'. Here’s how it works:

• More money in the economy can encourage spending and investment.
• Lowering interest rates makes borrowing cheaper, stimulating spending.
• It can help avoid deflation or reduce its severity by stabilizing prices.

By increasing the money supply, central banks aim to encourage consumers and businesses to spend rather than save, helping to offset deflationary pressures. The goal of these interventions is to stabilize the economy by ensuring that deflation doesn’t become entrenched, causing a long-term economic downturn.

Economic Spiral

An economic spiral occurs when initial economic changes cause further shifts, which in turn lead to even more significant changes in the same direction. In the context of deflation, it refers to a 'self-feeding spiral' that can be set in motion. Here's what happens:

• Prices drop, causing people to delay purchases.
• Reduced spending leads to decreased company revenues.
• Companies respond by cutting costs, often leading to layoffs.
• With lower incomes, consumer spending drops further.

This cycle of decreasing prices and spending can be difficult to stop once it starts. The more prices fall, the more consumers wait for even better deals, exacerbating the problem. It's crucial for policymakers to intervene early to prevent the spiral from gaining momentum, as prolonged deflation spirals can lead to prolonged and deep economic recessions.