Deflation means fall in the prices of goods and services.
Isn't deflation good then?
We probably think that deflation is good as the prices are falling. But we are wrong.
Here is a good example. Let us assume a company which is manufacturing steel and selling in the international market.
Company operates and expands its operations by taking loan from banks.
Let us assume company takes Rs. 100 as a loan amount and pays 10% interest on it.
If the economy goes through deflation then the price of steel are going to fall.
This will reduce the revenue and profit of the company.
But, company still has to pay interest of 10% on its loans and has to pay to its workers.
This will again reduce company's profitability.
As the steel prices are falling, people ,who buy steel in the market, will wait for further fall in prices.
This again puts pressure on the profitability of a company.
Company then fires its people and sell some of its plants in order to pay for its debt.
If company fires its people then there is going to be unemployment.
This will again reduce the demand for products and prices of steel will again fall.
This creates unending vicious cycle.
Recent happenings:
The example that I have mentioned is of TATA STEEL. In a recent time, they fired 1300 people from its U.K. division and sold some of its assets.
Japan is going through some serious deflationary cycle. Japanese government is trying hard to come out of this deflation. As the prices are falling, many auto companies in Japan are not investing because they think price will fall further. So no major economic activity is happening in Japan.
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Thanks Bhai 4 explanation.....
ReplyDelete1 query: u mentioned fall in commodity price= reduction in profitability.
But Fall in commodity price=reduction in purchase cost of commodity for company. Then why reduction in profitability?
What I understood: commodity price reduction over the time gap between purchase n final product makes difference.
Is it correct?
Also, fall in commodity price may be due to abundant supply or low market sentiments or some other factors.... Pls correct if wrong.... what the effects of these different causes.
Thanks Bhai 4 explanation.....
ReplyDelete1 query: u mentioned fall in commodity price= reduction in profitability.
But Fall in commodity price=reduction in purchase cost of commodity for company. Then why reduction in profitability?
What I understood: commodity price reduction over the time gap between purchase n final product makes difference.
Is it correct?
Also, fall in commodity price may be due to abundant supply or low market sentiments or some other factors.... Pls correct if wrong.... what the effects of these different causes.
Very good question...
Deletelet us go one by one.
companies are more globalized in this era. let us assume a steel company TATA STEEL. Company requires coal as a raw material.
company has its coal mines in Indonesia and Australia.
Company manufactures its steel in UK and India.
If the Indonesia's currency appreciates, then it would be very costly for TATA STEEL UK to import coal from Indonesia. So one part of globe will have inflation but other part may have deflation.
But whenever company decides to invest, it makes certain assumption that currency may fluctuate within certain range . If that assumption goes for a toss due to certain macro-economic conditions, then company will be in deep trouble.
Whatever you said about time gap is actually true.
this is what happens in actual scenario.
abundant supply and low market sentiments are actually responsible for deflation. and abundant supply capacities are created due to cheap credit line of money. So keeping control on cheap credit flow is mandatory. but this again will hamper the growth. so central bank of the country needs to balance these activities...
I hope this answers your questions...
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