Is deflation truly that bad for an economy?

[dinofelis]

First of all, if you do really borrow capital (which is a viable way of financing you working capital), the costs of it, that is interest paid, are already included in W_t1 (yet another entry in total costs).

Then W_t1 will be dependent on inflation or deflation, because the cost of the borrowing (the interest) will be higher in inflation (and W_t1 would be higher in inflation) and lower in deflation (and W_t1 would be lower in deflation).

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[louisLavery]

Since producers are more inclined not to reinvest their profits under deflation, thereby they have to cut production and lay off people (for reasons explained above). This directly hits on the consumer. Thus we have the consumer suffering in both cases, but deflation is more dangerous since it also hits hard on the producer. And not a trace of mirroring by any means.

It seems to me whether producers are more inclined to reinvest or not is immaterial, as I'm talking about a producer that's still producing.

Anyway, I think we're going to have to agree to disagree on this. I'll just finish with a generalisation of my #177.

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Let's assume it takes 3 weeks[1] to produce a good and we produce goods every 3 weeks.

The cost each week is w_0 = w, w_1 = w(1+p), w_2 = w(1+p)^2, thus w_k = w(1+p)^k    

The cost to make the 1st good is W_0 = w_0 + w_1 + w_2 = w((1+p)^3 - 1)/p
The cost to make the 2nd good is W_3 = w_3 + w_4 + w_5 = W_0(1+p)^3
 
The cost to make the kth good is W_3k = w_3k + w_3k+1 + w_3k+2 = W_0(1+p)^3k

Now, in #177 we were able to maintain R = 2W, can we still do that?
Yes, as the cost of making a good is (1+p)^3 times the cost of the prior good while prices are inflating at (1+p) per week, much like in #177. In fact the only real difference is that we start with a different value for W_0 (was W_1 in #177, I think).

So R_k = 2*W_K works just fine, and we can maintain a constant mark up (R/W = 2).

As with #177,  the deflation case is trivially the same, with p replaced by q = -p/(1+p).

[1] We can easily generalise to n weeks. Also, "weeks" can be generalised to any time period we chose.
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Let's do a quick analysis of profit (this is OTTOMH, so I'd welcome anyone pointing out flaws in the maths or logic)
I'll use g for gain. Note: g is a function of p, that is g = g(p).

g_0 = R_0 - W_0 = W_0

g_3 = R_3 - W_3 = W_3 = W_0(1+p)^3

So g is increasing/decreasing in line with inflation/deflation.  
So in real terms g = g(p) can buy the same amount of goods as g' can where g' = g'(0).
Thus neither inflation nor deflation is an incentive or disincentive to produce stuff.
Also consumers are no better or worse of under either inflation nor deflation.
Of course all this assumes wages and prices adjust in step each week (or whatever period we're using).
That doesn't necessarily mean the flations are not mirror images if that's not the case, but the analysis will be trickier, and interesting I think.  
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Thanks for taking the time to debate, it's always useful to have someone challenge your ideas, even if we don't agree on all points (or any).

[tee-rex]

You still don't see that it is not the same for deflation. In deflation you may end up with less money than you started with

No, you don't.  Well, if you do, you will ALSO loose when there is inflation.  Simply because of the higher interest you have to pay on your loan of W.

Imagine that you buy this year for $1000 of stuff, that the real interest rate is 6% and that inflation is 5%.  This means that the nominal interest rate is 11%.  You have borrowed your $1000,- at 11% interest rate.
Imagine your product is ready after a year, and it is worth 2% more in real terms as the cost.  So it would have been sold at $1020,-  this year, but because of inflation, you can ask $50 more for it next year (I'm not considering second-order effects).

So you can sell your stuff for $1070 next year.  However, you have to pay $110 of interest on your loan.  So net, you are LOOSING money: you gained $70 (20 value creation, and 50 inflation) but you have to pay $110 in interest), even though you sold for more than you bought.

---> $40 LOSS.

Let's say we have a zero real interest rate to simplify matters, since it is the same for both inflation and deflation. Also, we started with a condition that we are profitable at 0% inflation. What will your example be in these conditions, for inflation and deflation, please.

Let us now consider a value creation of 15%, with the same numbers.

5% inflation: you could have sold your product this year for $1150, but because of inflation, you can sell it next year for $1200,-
You have to pay $110 interest on your loan, so your net gain is $90.

5% deflation: you could have sold your product this year for $1150, but because of deflation, you can only sell it for $1100.-
You have to pay $10 interest on your loan, so... your net gain is STILL $90.

You get the same positive result since in both of your examples you effectively have inflation, 11% in the first case (6+5) and 1% in the second (6-5). Now let's talk about real deflation.

[dinofelis]

Let's say we have a zero real interest rate to simplify matters, since it is the same for both inflation and deflation. Also, we started with a condition that we are profitable at 0% inflation. What will your example be in these conditions, for inflation and deflation, please.

Of course, the real interest has to be larger than the deflation rate (which it normally is).  Otherwise, you will never get a loan !

But if you really want to do the calculation, which is silly, we can:

Suppose that you are profitable with 2% value increase.  That is, with no inflation, you will buy stuff for $1000, and you will sell it at $1020,-, you'll make $20 of profit.

Now consider 5% inflation.  The interest you now pay is 5% on your loan.  So you borrow $1000, and you have to pay $50 on it.
You will be able to sell your stuff for $1070,- because of inflation.

So you sell it for $1070, you pay $50 interest, and you pay back your loan of $1000.  Profit: $20.

Consider now 5% deflation.  We are now in the crazy situation where the actual interest is negative: you borrow $1000, and you'll have to pay negative interest: you will only have to re-imburse $950 (this is why you won't get a loan if the deflation rate is higher than the real interest rate).

You can sell your stuff now for $970.  You pay back your loan of $1000, and you receive $50 (your negative interest).

Net profit, again: $20,-.

Point is, that in a real economy, with fixed money supply, the real interest rate can never be lower than the deflation rate (which is equal to the economic growth).  Indeed, you don't want an interest rate that is lower than the *average* economic growth, do you !

[dinofelis]

You get the same positive result since in both of your examples you effectively have inflation, 11% in the first case (6+5) and 1% in the second (6-5). Now let's talk about real deflation.

Real interest rate is NOT inflation.

It is the price the market asks for having value tomorrow instead of today.  In investor terms, it is the average return on investment you can expect from your average-Joe production activity.

Real interest rate has even nothing to do with money itself or with currency.  

[tee-rex]

Let's say we have a zero real interest rate to simplify matters, since it is the same for both inflation and deflation. Also, we started with a condition that we are profitable at 0% inflation. What will your example be in these conditions, for inflation and deflation, please.

Of course, the real interest has to be larger than the deflation rate (which it normally is).  Otherwise, you will never get a loan !

We are not talking about loans! We are talking about producers who don't necessarily take loans but work on their own capital.

[dinofelis]

We are not talking about loans! And we are talking about producers who don't necessarily take loans.

The cost of putting money into something for a certain time is ALWAYS equivalent to borrowing that money.  Because you have to compare using the money the way you intend, with lending it out.

If you had to spend $1000,- and not have your product finished for a year, and interest rate is 10%, then you COULD HAVE OBTAINED $100 by lending it out during that year (placing it on a savings account, say).  So if you spend it on something, and you can sell your product only one year afterwards for $1050,- you have essentially LOST $50, as compared to putting your money on a savings account at an interest rate of 10%, or by lending it out at 10%.

Inflation or deflation has nothing to do with this.  If your return on investment is LOWER than the market interest rate, you lose in using the money for your investment.  You better put it on a savings account.

So you should always, if you need money in an example, consider that you borrow it.

[tee-rex]

Consider now 5% deflation.  We are now in the crazy situation where the actual interest is negative: you borrow $1000, and you'll have to pay negative interest: you will only have to re-imburse $950 (this is why you won't get a loan if the deflation rate is higher than the real interest rate).

You can sell your stuff now for $970.  You pay back your loan of $1000, and you receive $50 (your negative interest).

Net profit, again: $20,-.

You forgot that we agreed that interest rate is 0%, so you would have to return the same 1000$ (not 950$ as you pretend). But you can only earn 970$. In this case you incur a loss of 30$.

And then consider that you don't borrow but have $1000 as your own money. With the deflation of 5% you will get back only $970. You loss is same 30$, and in both of these cases you end up with less money than you had before.

Do you now get it?

[dinofelis]

If interest rate is 0%, you would have to return the same 1000$. You incur loss of 30$.

The *real* interest rate was 0%, which means that with a deflation of 5%, the NOMINAL interest rate is -5% (which is an absurdity, but why not).

It is in practice not possible to have a negative nominal interest rate, and deflation will always be less than the real interest rate normally, so that the nominal interest rate is still a positive number.

And now consider that you don't borrow but have $1000 as your own money. With the deflation of 5% you will get back only $970. You loss is same 30$, and in both of these cases you end up with less money than you had before.

Because we are in the absurd situation of a negative nominal interest rate.  If there is a negative nominal interest rate, you simply keep your money !  It would be absurd to invest into something that has less ROI than the deflation rate, which gives you a free interest.

However, that situation cannot last.  Because deflation (in fixed money supply) comes essentially about from the fact that the economy GROWS, and that more stuff has to be bought with the same quantity of money (assuming velocity more or less constant).

If the economy grows, it is normal to have a positive real interest rate, because the return on investment is normally HIGHER than the economic growth.  So normally, the real interest rate, which is of the order of the average return on investment, is higher than the economic growth which induces deflation.  As such, the nominal interest rate, which is equal to the real interest rate diminished with the deflation rate, will still be positive.

[dinofelis]

You forgot that we agreed that interest rate is 0%, so you would have to return the same 1000$ (not 950$ as you pretend). But you can only earn 970$. In this case you incur a loss of 30$.

REAL interest rate of 0% implies NOMINAL interest rate of -5% if deflation is 5%.  So you pay the nominal interest rate on a loan, which is now MINUS $50 (and which nobody will accord you).

[tee-rex]

You forgot that we agreed that interest rate is 0%, so you would have to return the same 1000$ (not 950$ as you pretend). But you can only earn 970$. In this case you incur a loss of 30$.

REAL interest rate of 0% implies NOMINAL interest rate of -5%.

If you borrow money at 0%, you will have to return the same amount that you borrowed (deflation, inflation, or whatever). I don't know what else is here to discuss. If you disagree, then you disagree, I have no more inclination to discuss this issue any further.

Actually, I don't already understand what you mean by real interest and what you mean by nominal interest.

[dinofelis]

If you borrow money at 0%, you will have to return the same amount that you borrowed. I don't know what else is here to discuss.

If you borrow money at 0% NOMINAL RATE, and deflation is 5%, it means the REAL INTEREST RATE is 5%.  Not 0% as you pretended.

Now, if the real interest rate is 5% (which becomes 0% nominal rate at 5% deflation), it would become a nominal interest rate of 10% if there were 5% inflation.

Because nominal interest rate (the one you have to pay) i = i0 (the real interest rate) + p (inflation, or negative if deflation).

In other words, if the market determined a real interest rate of 5%, and there is 5% deflation, the nominal interest rate on a loan will be 0% (you give back what you got) ; if there is 5% inflation, the nominal interest rate will be 10% (you have to give back 10% more than what you got after a year).

The real interest rate is related to the expected average return on investment of capital in the economy (independent of any currency and hence independent of any form of inflation or deflation).

You don't seem to understand that the nominal rate you have to pay on a loan (or that you get on a savings account) includes a correction for inflation from the real interest rate.

[dinofelis]

Actually, I don't already understand what you mean by real interest and what you mean by nominal interest.

http://www.investopedia.com/articles/investing/082113/understanding-interest-rates-nominal-real-and-effective.asp

Nominal interest rate – Inflation = Real interest rate

A hypothesis maintains that the inflation rate moves in tandem with nominal interest rates over time, which means that real interest rates become stable over longer time periods. Investors with longer time horizons may, therefore, be able to more accurately assess their investment returns on an inflation-adjusted basis.

[tee-rex]

If you borrow money at 0%, you will have to return the same amount that you borrowed. I don't know what else is here to discuss.

If you borrow money at 0% NOMINAL RATE, and deflation is 5%, it means the REAL INTEREST RATE is 5%.  Not 0% as you pretended.

Okay, you borrow money at 0% interest rate (that means that you will have to return the same amount you borrowed, you name it), which is essentially the same if you just had that money. Inflation as well as deflation is 5%, your profit margin is 2%, when will you suffer losses, and when will you earn profits?

[twiifm]

I agree.  What you described connects to Keynes "sticky prices" and "sticky wages".

In deflation period firms can't automatically adjust prices.  What they do is cut expenses.  Usually the first is layoffs

Ah, the ultimate argument when it is shown that all principal effects of inflation and deflation are economically essentially neutral and mirror of each other if you take all effects into account.

Point is, stickiness of prices are only valid in the short term.  Otherwise, nobody would even be willing to pay $1.- for a loaf of bread, given that we are used to 10 cents for it !

Stickiness of prices is just as well an argument against inflation as against deflation (and in fact, implies that inflation and deflation should be MILD).  Consumers DO adapt to higher prices in inflation.  They are not holding on to any "stickiness" in the long run.  They adapt to the market: if there ain't any more at the old, lower prices, they are willing to pay higher prices.

The stickiness of prices in wages and so on only comes about because of LEGISLATION which does some kind of price fixing.  If those prices were just as free as a loaf of bread, and the labor market would be fluid, then wages would adapt just as well as the price of a loaf of bread.

If you have an inflation of 2%, you have an effective wage drop of 2% a year, and you have to negociate a wage increase to keep the same effective wage.  If you have a deflation of 2% a year, you'd get an automatic wage increase of 2% a year.  First of all, that is not so terribly uncommon.  And second, there could be wage lowering negociations from the side of the employer.  They would in times of deflation be just as natural as wage increase negociations in times of inflation.

There is no long run stickiness of prices.
Markets always impose prices.

Wages arent negotiated down.  Layoffs happen and you see increase of unemployment.

Were you asleep the past 7 years?.

Stickyness of prices doesn't mean market doesnt control prices.  It means the adjustment lag behind and explains why deflation can spiral. 

[dinofelis]

Wages arent negotiated down.  Layoffs happen and you see increase of unemployment.

Were you asleep the past 7 years?.

Wages don't have the tradition to be negociated down because we live in an inflation-induced world since 1914 (and before that, there wasn't much like collective wage negociation tradition).  All our social and economic traditions are based upon an inflationary money.

If deflation were standard, it would be just as normal to have a negotiation downward of wages.

Stickyness of prices doesn't mean market doesnt control prices.  It means the adjustment lag behind and explains why deflation can spiral. 

Deflation can spiral just as much as inflation can spiral.  They are duals.

[dinofelis]

Okay, you borrow money at 0% interest rate (that means that you will have to return the same amount you borrowed, you name it), which is essentially the same if you just had that money. Inflation as well as deflation is 5%, your profit margin is 2%, when will you suffer losses, and when will you earn profits?

The point is that the nominal interest rate is not the same when there is inflation and when there is deflation.

Nominal interest rates (those you have to pay) will be much higher in an inflationary situation than in a deflationary situation.  That's the whole point.

In the 70-ies, when there was 2-digit inflation, you also had 2-digit interest rates on a savings account for instance.

The more there is inflation, the higher will be the interest rates.  The more there is deflation, the lower will be the interest rates. So you can't say "let's keep the (nominal) interest rate constant - say 0% - and calculate the case of inflation and deflation".

[tee-rex]

Okay, you borrow money at 0% interest rate (that means that you will have to return the same amount you borrowed, you name it), which is essentially the same if you just had that money. Inflation as well as deflation is 5%, your profit margin is 2%, when will you suffer losses, and when will you earn profits?

The point is that the nominal interest rate is not the same when there is inflation and when there is deflation.

Nominal interest rates (those you have to pay) will be much higher in an inflationary situation than in a deflationary situation.  That's the whole point.

In the 70-ies, when there was 2-digit inflation, you also had 2-digit interest rates on a savings account for instance.

You were claiming that deflation is a mirror image of inflation, right? Now you seem to be backpedaling this issue, how come? Why don't you just accept that you were wrong?

We agreed to start at 0% inflation-deflation rate where nominal interests rates would be close to zero, then inflation-deflation would kick in. If the business was profitable at 0% inflation, it will most certainly stay profitable in the inflationary environment too, while in the deflationary environment it is not given, which can be proven mathematically. Deflation is not mirroring inflation!

[dinofelis]

You were claiming that deflation is a mirror image of inflation, right? Now you seem to be backpedaling this issue?

Not at all.  Where do you get that ?  Inflation increases nominal interest rate, deflation decreases nominal interest rate.  Symmetric, no ?

We agreed to start at 0% inflation-deflation rate where nominal interests rates would be close to zero, then inflation-deflation kicks in.

Yes.  If the nominal interest at 0% inflation/deflation is 0%, then the REAL interest rate is 0%.  The nominal interest rate will then be equal to the inflation/deflation rate, because the real interest rate is unchanged, here 0%.

That means that if we have inflation of 5%, the (nominal) interest rate will be 5% ;
if we have deflation, the (nominal) interest rate will be -5% (which is, as I said, an absurdity, but which comes because of your starting assumptions of having a real interest rate of 0% and nevertheless deflation, which is economically difficult to consider).

In the no-inflation case, you buy for $1000.-, you pay 0 interest (nominal rate = real rate here is 0), and you sell for $1020 (if your ROI is 2%).

You make $20 profit.

In the inflation case, you buy for $1000,-, you pay $50 interest, you can sell for $1070, and you make again $20 profit.

In the funny deflation case, you buy for $1000, you pay minus $50 interest (that's what it means to have a negative interest) - that is, you only have to reimburse $950, you can sell for 970, and you AGAIN make $20 profit.

The only point being that nobody is going to borrow you money at a negative nominal interest rate.  But that is because you wanted to consider the case of 0% real interest rate and nevertheless deflation.

If the business was profitable at 0% inflation, it will most certainly stay profitable in the inflationary environment as well, while in the deflationary environment it is not given.

I exactly calculated you the opposite.

[tee-rex]

You were claiming that deflation is a mirror image of inflation, right? Now you seem to be backpedaling this issue?

Not at all.  Where do you get that ?

Here is your post. It seems that I remember them better than you do:

If you now correct the interest rate for the inflation (that is, i = i0 + p), you will find that inflation or deflation is totally indifferent.