Deflation In A Nutshell

I have never seen a textbook that gave a good analysis of deflation, so I put together my own. It really isn't that complicated.
Deflation is negative inflation. It is a decline in the average price level which is the same thing as an increase in the real value of money. We have had very large deflation in computer hardware prices for the past half century, but this is not what people usually mean when they talk about deflation because most nominal prices have still been going up.  Deflation comes from two sources:

• Increased money demand due to increased productivity which lowers the real price of goods and increases output and incomes.  This kind of deflation was relatively common under the gold standard because the money supply could not grow to accommodate economic growth. Under fiat money, deflation is rare because central banks expand the money supply to keep up with economic growth.
  
• Declining money supply due to a drop in the monetary base or a drop in the money multiplier (the willingness to make loans).  This is worse than the other cause because it is usually caused by some kind of economic crisis and it further decreases aggregate demand and exacerbates recession.
  

What causes increasing declining money supply and/or increasing money demand?

• Declining money supply is caused by central bank policy and/or individual banks becoming less willing to lend out money. In 2008 banks became insolvent and many ceased lending money which tends to contract the money supply. This was also a problem during the Great Depression when banks not only became insolvent, but many went bankrupt and even healthy banks were reluctant to loan out money because they were afraid of ‘bank runs’ by their depositors.
• Once central banks lower their interest rates to zero, they have no more ability to increase money supply using this conventional tool.
• Instead they can do “quantitative easing” and “unconventional monetary policy” which is more experimental. The central bank increases the money supply by buying up securities from banks, giving them new money to lend. These securities could be government bonds, commercial loans, asset backed securities, or even stocks.
  
• Alternatively, they could actually print more cash to increase the money supply, but they are loathe to do that for fear of losing investor confidence and future inflation. The US government borrows vast amounts of money each year and if they began printing money, they might have a hard time continuing to borrow money. I’m not sure these fears are rational. Nobody has ever tried it to combat deflation. Usually printing money is caused by governments that cannot raise taxes nor borrow money and printing money is the only way that they can pay for stuff. Printing money is associated with economic collapse because it is often caused by economic collapse and in normal times it causes hyperinflation, but a deflationary spiral is NOT normal times. This is a risky option for combating deflation simply because nobody has tried it and so the empirical result is completely unknown.
  
• Increasing money demand is caused by
• Expectations of deflation. If you expect 5% deflation, that means that cash gives you a real return (risk free) of 5%/year! Cash becomes a good investment whereas during inflation it is not an investment, but something that is costly to hold and is mainly used for transactions rather than as a store of wealth.
• Deflation of other assets in investor portfolios means that the prices of stocks, bonds, and land are going down. If you think your other investments are going down in value, then you would be better off to sell them and hold more cash.
  
• Expectation of higher risk in other portfolio options. If the stock market and bond market experience higher volatility and greater chances of default, then money becomes less risky in comparison.
• If you think that you might loose your job, then your appetite for risk goes down and you would be more likely to transfer some of your portfolio out of more risky assets like stocks and long-term bonds towards more liquid assets like cash.
  
• Both of these factors (increasing money demand and decreasing money supply) tend to happen at the same time during a general deflation.
  

Problems caused by deflation:

• It raises the real interest rate = the nominal market rate minus inflation. (Thus if prices fall 5 percent per year and the nominal interest rate is a modest 3 percent, the real interest rate is actually a high 8 percent.)
• Real interest rates (r) must be larger than the negative deflation rate because the opportunity cost of lending money is to just keep it buried in a vault and it increases in value risk free.  Also r = i - inflation and because nominal interest rates (i) are always positive, the real interest rate (r) must be bigger than the negative inflation rate.  A big deflation then forces big real interest rates which hurts investment.
  
• Nominal interest rates cannot be negative. Nobody is going to pay you to borrow their money. Ever.
• Deflation rewards creditors and those with cash at the expense of debtors and those with illiquid assets.
• Can increase foreclosure problems. Incomes decline, but real loan payments do not decline (or not as much as incomes decline). This increases lending costs and also pushes up real interest rates.
  
• Deflation increases the incentive to save and decreases the incentive to borrow which decreases aggregate demand.
  
• It increases the real value of debt which increases loan defaults because nominal wages (and incomes) decline, but nominal loan payments are fixed. Higher defaults and foreclosures further reduce bank lending which reduces the money supply (see above).
  
• Decreases aggregate demand due to expectations of lower future prices.
• ↓C: consumers will tend to delay discretionary purchases if they anticipate that prices will drop.
  
• ↓I: Businesses that are able to expand will tend to choose not to expand if they anticipate that prices will drop.