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Author Topic: Understanding deflation  (Read 1013 times)
niklas_a
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June 04, 2011, 10:19:13 PM
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This is a question on deflation. Let's avoid turning it into a discussion on Bitcoin and if it is deflatory, mmkay?

When I put my hard-earned money in the bank in a savings account it increases in value over time.
The argument I hear against deflation is that people will avoid spending money since their money increases in value.

Yet, even though the wisest decision for me would be to save money in my savings account and let it increase in value I end up spending money.

How do this scenario differ from an economy experiencing deflation?

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prolixus
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June 04, 2011, 10:28:20 PM
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Because of pre-existing debt. When unexpected deflation occurs real interest rates on existing debt spike, and because of lower prices on goods and services businesses may not have the cash flow to pay their debts even though in a stable price environment they would be profitable.

When the banks that made the loans to the businesses are forced their losses on a default they in turn can default on their creditors, i.e. people who have made deposits and purchased bonds, creating a cycle of financial failure.
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June 04, 2011, 10:29:52 PM
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When I put my hard-earned money in the bank in a savings account it increases in value over time.

No. The rate of inflation is higher than the rate you're given on your savings, which means that while the actual number you see indeed goes up the purchasing power (e.g. value) goes down.

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June 04, 2011, 10:30:37 PM
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I totally agree, Bitcoin's "deflationary" aspect is one of its best features because it replaces the soon-to-be ancient requirement of an individual having to use a "savings account" at a bank controlled by a 3rd party to store their money, thereby receiving interest on your funds by putting your money into the hands of someone else.  Instead, you can hold the bitcoins yourself and have complete self autonomy (i.e., no one else controls them for you, amazing, freedom rocks!) and you'll still be rewarded for not being a spend-aholic.

wareen
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June 04, 2011, 10:48:35 PM
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Quote
How do this scenario differ from an economy experiencing deflation?
One of the differences is, that overall the money is still losing value - you only make up for it by the interest the bank is willing to pay you. The interest rate a bank pays is usually bound to a base rate (federal funds rate) controlled by the government. The government therefore has still control over the development of the monetary value and it will usually avoid raising the base rate to a level which would equal significant deflation.

Inflation can be limited by increasing the base rate, therefore giving people more incentive to save instead of invest. This can be used to slow down economic growth which might otherwise be too fast (as currently in China for example).

Deflation on the other hand cannot be limited indefinitely via governmental control of the base rate, because if the base rate is already zero it can't be lowered any more.
Therefore, in a deflationary economy, the government usually has little control over the development of the economy. If it is already shrinking and money is deflationary (for whatever reason) it might cause the infamous deflationary spiral and it is very hard to get out of it.

Control of the development of monetary value (degree of inflation / deflation) via the base rate is probably the most direct and effective way a government (or rather the Fed) can influence the growth of the economy - unfortunately this control mechanism only really works for inflation.
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June 04, 2011, 10:54:56 PM
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http://www.bitcoinweekly.com/articles/one-apple-today-two-apples-tomorrow-or-how-i-stopped-being-afraid-and-learned-to-love-deflation

My magazine have an article on why deflation might be good.

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