What would be a common man reaction to a fall in price of goods and services, well the answer is that of happiness and relief because everybody likes low prices for goods and services. However too much decrease in the price of goods and services is not good and it leads to deflation. Deflation can be defined as a decrease in the general price of goods and services. Deflation happens when inflation rate fell below zero percent, in other words a country has negative inflation rate. Deflation can be a vicious circle, let’s see how –
1. As the deflation sets in or during the initial phase of deflation, when prices fall rapidly, the cost of production does not fall correspondingly which leads to losses to producers or companies resulting in lowering of their profits.
2. Since the profits of companies decline they try to reduce their cost by reducing the number of workers which in turn curtail employment and results in fall in aggregate income of the people.
3. As the income of the people began to decline demand for goods and services began to decline which further reduces the prices of goods and services.
4. Since there is low demand for products companies reduce the production which leads to further increase in unemployment and income, business activity comes to standstill and it is a situation in which there are plenty of resources but nobody want to use them due to lack of demand and the pessimism which sets in during deflationary periods.
As one can see from above deflation is a vicious circle and that is why if governments are given a choice between deflation and inflation, they will always go for inflation.