(FIG 4) State of world economy
As can be seen from (Fig 4), the world economy is below the natural rate of output. The aggregate demand curve has shifted inwards, this is in line with the IS curve shifting inwards too. The reason for this occurring is because of supply-side structural factors. Increases in levels of imports of manufactured products from China and other Asian countries, that have expanded their supply capacity are depressing product prices. This has been the case in Japan. The decline in prices has been caused by a contribution of demand factors due to a lack of strength in the economy. Especially after the burst of the technology bubble, Japans stock markets crashed, this crippled investment spending by firms, consumer confidence in the market plummeted and this led to a decline in aggregate demand. Overall the world economies have become too highly competitive, have created overproduction and forced reductions in prices; all of which stimulates deflation
Deflation is expected to have adverse effects on the economy. It increases the effective debt loads of firms, particularly of firms with excessive debts, working as a restraint on business investment. Furthermore in the case where nominal wages and interest rates do not decline as much, the real wages and interest rates will increase, therefore depressing a firms profits, limiting business investment, thereby slowing down economic growth and increasing unemployment. In the US one of the fears of deflation is that debtors are paying creditors with more valuable dollars, which transfers wealth from debtors to creditors. Due to a fall in demand, firms need to cut costs of production. Firing more people and hiring less people achieve this. At present, the unemployment rate in US is 5.9%, whereas in 2001 it was 4.8%. Therefore showing a rise in unemployment. If the unemployment level exceeds the natural rate of unemployment, in line with the Phillips Curve: πt-πet = -α(ut-un), inflation will be depressed even further, thereby causing a deflationary escalation to occur. Okuns law ut-ut-1 = (gyt-3%) states that output has to be at 3% to keep unemployment constant. This is different to Blanchard’s rule, which states that a change in unemployment is equal to a change in output. Now if the economy growth rate of output is below 3% Okuns law states that unemployment will rise. As shown from the data collected, the US is below the natural rate of output. Currently the saviour of the US economy is the middle class consumer. This is because the consumer is borrowing. If unemployment rises, the consumer will stop buying and start saving more. This in turn will lead to lower aggregate demand and a downward spiral of lower prices. Deflation could also prompt people to withdraw from consumption by causing them to expect a continued decline in prices and increasing people' s uncertainty about the future direction of the economy. If prices decline and demand is decreasing it can have negative effects on business profits as cutbacks on personal expenses lag behind the price decline. Sliding companies lead to sliding employment and sliding demands for consumer and capital goods
There are strategies that can be adopted by policymakers to tame deflation. As we learnt earlier, the world economy is below the natural rate of output, thus a monetary expansion policy would bring the economy back in equilibrium (Fig 5).
(Fig 5) Monetary expansion
Theory states that a decrease in interest rates shifts the aggregate demand outwards (A’) and the LM curve moves downwards. The shift in aggregate demand increases the money supply. Point (B) is never reached because an increase in money supply increases price level, which has an offset effect of reducing the money supply. As price expectation levels catch up with actual price levels, aggregate supply shifts inwards (A’’). The shift in the LM is a rapid adjustment, whereas the shift in aggregate supply is a much slower process. Overall in the short run output will increase but in the long run output will return to its natural rate. Output cannot be maintained over the natural rate of output (neutrality of money). Therefore this monetary expansion policy can be adopted for our current world economy to fight deflation and for us to return back to the natural rate of output. But there is a problem. This monetary expansion policy lowers the interest rate, but as can be seen from (Fig 6), current interest rates are already low in US and Japan. Therefore it is not feasible to lower interest rates any more as they could result in a negative return. At present Japan has already exhausted its monetary policy, having failed to stimulate demand in the economy. This can be seen in (Fig 3) with Japan having decreasing retail sale figures. The other option is to use fiscal policy to stimulate demand. The government in US has intervened by refunding taxes, troubled industries are receiving government loans and long term bonds are not being issued any more. Even the use of fiscal policy such as reduction in taxes to increase the wealth of the consumer and stimulate demand, would mean a reduction in interest rates. Again this is not a viable option. In Japan measures to respond to deflation have been implemented, some include immediate disclosure of the findings of special inspections of major banks so that doubts concerning non-performing loans are eliminated and the public's faith restored. Measures to restore confidence include efforts by the Bank of Japan to provide liquidity for financial institutions. The Bank of Japans new financial policy will include price level targeting, which include adjustments to financial markets with a target of raising consumer prices by 1-2% per year.
Finally to answer the question at hand concerning whether deflation is the biggest risk facing the world economy. There are other risks facing the economy, but deflation appears to be the root cause of many of these problems, such as diminishing investments, poor consumption, as a result mark declines, profit margins decrease, businesses become less competitive, productivity declines and costs of production rise. This leads to a rise in unemployment and the economy as a whole suffers. Once the economy enters the deflationary spiral, it is very difficult to escape out of it. Only over a period of time, will consumers’ attitudes change and progress can be achieved. Even through effective monetary and fiscal policy deflation cannot be completed avoided, but countermeasures can be take to dampen the effects of deflation.
