Trading Essentials
What Is Deflation? The Impact of Deflation on the Forex Market
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26/07/2023
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what is deflation

Recognizing the phenomenon of inflation and deflation is important. Traders and Investors should know the market situation to make the right decisions and avoid financial risks. In the previous article, FXCE provided information about inflation. You can read What Is Inflation? Impacts Of Inflation On The Forex market.

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What is deflation?

Deflation is an economic term for the general decline in the price level of goods and services. Deflation occurs when a country’s economic market’s supply price level declines. This is the opposite of inflation. Deflation occurs when the inflation rate goes below 0%. To put it, deflation is when consumers can buy more things for the same amount of money.

The country's currency will be more valuable in monetary and financial terms. For example, the Vietnam Dong and the USD Dollar. In normal times, it costs 23,000 Dong to buy one Dollar; in deflationary times, it cost only 20,000 Dong.

In short, deflation occurs when commodity prices decline. And it differs from dropping prices only in one way. The decrease in prices will not become deflation if service prices increase instead.

Causes of deflation

Many different causes lead to deflation. We would think deflation brings benefits to consumers when they can buy more goods. But in reality, the deflationary economy will severely affect.

what is deflation

The decrease in total demand

The decline in total demand in the country is the leading cause of deflation. The imbalance of supply and demand in the market will lead to a larger supply than demand. Excess of goods compared to consumption demand will cause prices to fall. But this must be the case with some specific industry groups.

The reduction in prices of goods will cause the company's revenue to decrease. Thereby cutting workers and shrinking production is inevitable. As a result, the size of the economy may shrink and increase unemployment. It will lead to social instability.

Increase productivity

Science and technology development has helped the company/ enterprise operate more effectively. This is another cause of deflation. Since then, reducing product costs is inevitable when supply is greater than demand. Now consumers benefit by lower selling prices, the same amount but now they can buy more goods.

However, this situation is very unlikely because most businesses put the profit target on top. They will only reduce the price up to a certain level to have a competitive price in the market.

deflation

Change in a firm's capital structure can lead to deflation

The change in capital market structure helps businesses have more options to optimize production. When the state offers support policies with low-interest loans. It will create conditions for businesses to increase investment capital.

Many suppliers of the same type of goods/services can lead to lower products. New businesses that want to access a new capital structure need to lower product prices to attract products. It is this action that will lead to deflation.

Money flow has a downward change (a decrease in the money supply)

Central banks are primarily responsible for the money supply. When an economic downturn occurs, the state will reduce the money supply to tighten spending. Now the central bank will take measures such as selling government bonds or changing capital market policy. This leads to a decrease in the money supply leading to an increase in the value of the currency. When the value of the currency is higher, the price of goods will also be dragged down. The result will create deflation.

The effects of deflation

deflation

The fact that the money we hold in our hands can buy a wider variety of goods seems like a good thing. However, any economic problem will bring positive and negative effects if over in time. Like inflation, deflation will bring great damage when going on for a long time. Check out the effects below.

Positive impacts

When deflation derived from labor productivity will create a positive impact. This proves that there is progress in science and technology. Creating a premise for the development of the economy. Besides deflation It also creates an open business environment, minimizing monopolies. From there, building a free market helps to improve competitive efficiency.

Competitive efficiency increases, and businesses make the most of resources. Above all, consumers will be the first beneficiaries of the benefits. When deflation happens, they have the opportunity to access a variety of goods and services with much more favorable funding.

Negative impacts

  • Impact on economies of scale

When the size of the economy is in danger of recession and serious decline before the impact of deflation. Stagnant goods will affect cash flow, affecting business revenue.

In the long term, the profit of the business will not stop decreasing. This prolonged situation is the reason why many businesses are forced to reduce production, and even go bankrupt. The scale of the economy was severely affected.

  • Difficulty in investing and reinvesting

When this happens deflation means that when the currency appreciates, consumers tend to hoard more money. Instead of cash circulation through investment activities, savings, asset purchases, and sales. Consumers will keep their idle money.

This makes it difficult for banks when there is a lack of money to lend, and businesses cannot rotate capital. When there is a shortage of domestic currency, businesses lack capital because capital flows congest. Investment and reinvestment activities due to lack of capital will also delay.

deflation

  • Reduce production scale

Commodity prices fell to the lowest level, affecting the profits of enterprises. They face the problem of how to balance costs and revenue. The scale of production forces to reduce the load and the reduction of manpower is inevitable.

  • Negative impact on labor value, value for money, and value of goods

The mass reduction in revenue and profit is a big shock to the economy. Deflation occurred causing the currency to appreciate while the price fell. Employees face the risk of salary reduction. Because a series of businesses have to adjust compensation for damage when deflation takes place. Followed by debt default, unemployment, bankruptcy, reduced profits, ...

The relationship between Deflation and Inflation

deflation vs inflation

Deflation and inflation are two opposite and consecutive processes as trends. Deflation And how is inflation different? Take a look at the table below:

Comparative Criteria

Deflation

Inflationary

Define

A decrease in the prices of goods and services in an economy

An increase in the price level of goods and services in the economy

Reason

*Production efficiency: prices of goods/services decrease due to technological innovation

*Reduced money supply: This causes the prices of goods and services to fall to make the products affordable to the masses

*Money surplus: When the domestic money supply increases above economic growth, the value of the currency will decrease

*Pull demand: Suppliers can increase the price of goods/services due to increased user demand

*Cost-push: When companies face rising production costs, they can raise the price of goods to maintain profit margins

Benefit

Deflation is considered harmful to the economy. However, it is beneficial for consumers

Moderate inflation is considered good for the economy. However, it only benefits the producers of goods and services

Impact

This situation causes the demand for money to increase. In addition, the demand for products and services decreases during this time

Inflation causes the value of money to decrease. At the same time, the demand for products and services also increased.

Consequence

Deflation causes businesses to reduce investment and spending, easily leading to an increase in the unemployment rate

Unequal distribution of income

Deflations happening around the world

deflation

Although less mentioned and concerned with inflation, deflation happened in several countries around the world. This includes very developed economies.

  • USA

The US economy has gone through one of those periods of deflation. The longest period was from 1980 to 2015. During the 1970s, a rapid increase in inflation was known as “Great Inflation”. This occurred with prices increasing by more than 110% over the decade. To change this situation, the Fed has implemented monetary policies to reduce inflation.

The price increase has slowed down and was as low as 9% between 2010-2015. During this period, deflation took place and brought about positive effects.

  • Japan

The Japanese economy has been in crisis since the asset bubble burst in the early 1990s. The Bank of Japan (BOJ) has made some mistakes in monetary policies. This leads to the official economy falling into deflation in 1998.

In the two decades from 1990 to 2010, although the money supply increased, it still could not pull the economy out of deflation. By October 2016, inflation had appeared in the world's third-largest economy. Shows that the policies applied have been effective.

  • China

In June 2023, China recorded zero inflation for the first time in two and a half years. Although the previous expectation was to maintain the level of 0.2% in May. Many data show that China facing the danger of deflation increased due to CPI reaching zero and PPI decreasing. The reason comes from the somewhat weak economic recovery after the pandemic. People are not willing to spend but want to save and hoard their money.

While countries around the world are facing inflation, this new situation in China said that it goes against the global trend. For policymakers, if deflation Long term it can be very dangerous. Currently, the government and the Central Bank of China are making efforts to change the situation of deflation.

Impact of Deflation on the Forex Market

deflation

Any change in the global economy affects investment and trading. We should note that although deflation is beneficial for consumers. It can also impact the financial sector. An example many economists give is that borrowers have to pay back more money than they borrowed.

In the Forex world, central banks play an important role. For example, if deflation causes by low demand and poor corporate profitability. The country's currency may fall and foreign investors may lose favor.

That is why there is no doubt, deflation is a moving mover in Forex. When trading USD/JPY and USD/EUR - two popular currency pairs - the fear of deflation can attract investments in the dollar.

Forex Trading During Deflation

deflation effect

Whether positive or negative, traders also need to stay calm and have suitable trading strategies. Some trading experience traders can apply during this period deflation takes place.

  • Even in the situation of deflation or not, trading knowledge also needs to be invested enough. Traders can learn from reputable official sites like FXCE’s Blog, financial news sites, or the trading community.

  • Always create a disciplined trading habit, and control trading risks (can automate with technology products like FXCE Trader Guard)

  • Depending on your goals, explore different trading options and strategies. Establish a consistent trading strategy. Because consistency is the key to your success in Forex.

  • Always keep an eye on various financial indicators, social issues, and news announcements. As many factors affect the world economy in general and Forex trading in particular.

  • Understand the importance of trading psychology and learn to control your emotions. In particular, you should not trade in a greedy mood but need to be calm.

  • Accept that the Forex market is changing. So always have contingency strategies ready and pay attention to risks.

Conclude

In short, deflation occurs when the prices of goods and services tend to decrease. When the level of inflation falls to negative levels. Deflation also has different positive and negative effects. They are often applied to correct an economy with high inflation. But deflation can also become negative when going on for a long time and left unchecked.

Traders also need to watch the market for signs of deflation to have a suitable trading strategy. Please follow FXCE Blog to be able to read the next interesting and useful articles.

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