Good, bad and benign deflation

Economists sometimes distinguish between good and bad deflation. However there is probably a third category of benign inflation.

Good, bad, benign deflation

Bad deflation. This is caused by decreased demand and is usually related to severe contractions in the money supply and/or reductions in the velocity of money. Normally contractions of the money supply occur in conjunction with financial crises and especially banking ones. In these events, banks restrict the amount of credit, interest rates often rise and money is destroyed either through defaults or net paying back of credit. These usually lead to asset price deflation (i.e. reductions in house prices, shares etc.) and sometimes to goods and service deflation (e.g. CPI/RPI). These situations are also normally accompanied by people saving more, coupled with simultaneous reductions in the velocity of money which amplify the effect caused by the shrinking money supply.

Good deflation. This is caused by reductions in the cost of goods. This can come about for a number of reasons. The main ones seen recently include: technological improvements (think computers), the digital revolution (which has reduced prices across many sectors), globalisation of production (e.g. outsourcing production to cheaper countries), reductions in labour costs (due to reduced trade union power, privatisations etc.), reductions in the costs of raw commodities (think of the recent declines in the oil price) and finally by appreciation of the local currency versus other producer nations.

The distinction is arguably more complicated than this, as there are different causes of decreased demand for goods and they should not all be grouped under the bad deflation banner. The most frequently experienced reason for decreased demand is related to financial crises and this does deserve the term bad deflation. However demand can also be lower due to population changes as we have witnessed in Japan. Here the working population has shrunk and this has caused a decline in economic production. The ageing population also consumes less. Both of these have been a downward force on prices. However it is unhelpful and somewhat misleading to group this type of decrease in demand into the bad deflation category. Perhaps a better description would be to add a third category of benign deflation.