Question

The theoretical case for how deflation arises (rate of growth of money supply relative to the rate of growth for the demand for money.

Answer 1

Deflation, or negative inflation, happens when prices fall because the supply of goods is higher than the demand for those goods.

In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below 0% (a negative inflation rate). Inflation reduces the value of currency over time, but deflation increases it. This allows one to buy more goods and services than before with the same amount of currency.

Deflation usually happens when supply is high (when excess production occurs), when demand is low (when consumption decreases), or when the money supply decreases (sometimes in response to a contraction created from careless investment or a credit crunch). It can also happen as a result of too much competition and too little market concentration.

Let us take the case of Japan's deflation.

Deflation started in the early 1990s. The Bank of Japan and the government tried to eliminate it by reducing interest rates and 'quantitative easing', but did not create a sustained increase in broad money and deflation persisted. In July 2006, the zero-rate policy was ended.

Systemic reasons for deflation in Japan can be said to include:

• Tight monetary conditions. The Bank of Japan kept monetary policy loose only when inflation was below zero, tightening whenever deflation ends.
• Unfavorable demographics. Japan has an aging population (22.6% over age 65) that is not growing and will soon start a long decline. The Japanese death rate recently exceeded its birth rate.
• Fallen asset prices. In the case of Japan asset price deflation was a mean reversion or correction back to the price level that prevailed before the asset bubble. There was a rather large price bubble in stocks and especially real estate in Japan in the 1980s (peaking in late 1989).
• Insolvent companies:  Banks lent to companies and individuals that invested in real estate. When real estate values dropped, these loans could not be paid. The banks could try to collect on the collateral (land), but this wouldn't pay off the loan. Banks delayed that decision, hoping asset prices would improve. These delays were allowed by national banking regulators. Some banks made even more loans to these companies that are used to service the debt they already had. This continuing process is known as maintaining an "unrealized loss", and until the assets are completely revalued and/or sold off (and the loss realized), it will continue to be a deflationary force in the economy. Improving bankruptcy law, land transfer law, and tax law have been suggested (by The Economist) as methods to speed this process and thus end the deflation.
• Insolvent banks:  Banks with a larger percentage of their loans which are "non-performing", that is to say, they are not receiving payments on them, but have not yet written them off, cannot lend more money; they must increase their cash reserves to cover the bad loans.
• Fear of insolvent banks:  Japanese people are afraid that banks will collapse so they prefer to buy (United States or Japanese) Treasury bonds instead of saving their money in a bank account. This likewise means the money is not available for lending and therefore economic growth. This means that the savings rate depresses consumption, but does not appear in the economy in an efficient form to spur new investment. People also save by owning real estate, further slowing growth, since it inflates land prices.
• Imported deflation: Japan imports Chinese and other countries' inexpensive consumable goods (due to lower wages and fast growth in those countries) and inexpensive raw materials, many of which reached all time real price minimums in the early 2000s. Thus, prices of imported products are decreasing. Domestic producers must match these prices in order to remain competitive. This decreases prices for many things in the economy, and thus is deflationary.
• Stimulus spending: According to both Austrian and monetarist economic theory, Keynesian 'stimulus' spending actually has a depressing effect. This is because the government is competing against private industry, and usurping private investment dollars.
• In 1998, for example, Japan produced a 'stimulus' package of more than 16 trillion yen, over half of it public works that would have a quashing effect on an equivalent amount of private, wealth-creating economic activity.Overall, Japan's 'stimulus' packages added up to over one hundred trillion yen, and yet they failed. According to these economic schools, that 'stimulus' money actually perpetuated the problem it was intended to cure.

In November 2009, Japan returned to deflation, according to the Wall Street Journal. Bloomberg L.P. reports that consumer prices fell in October 2009 by a near-record 2.2%.