Is deflation a precursor to depression?
The short answer to the question is deflation
a precursor to depression is, "usually."
The long answer is much more useful.
Economic contraction begins with a conspicuous lack
of demand for goods and services in relation to their
production, when valued at current prices. As the
absence of demand develops, prices for goods and services
fall. This is where the deflationary
spiral takes hold. Falling prices signal producers
to cut back production. In response, total production
declines.
Economic contractions come in different sizes. Economists
specify only two, which they label "recession"
and "depression." The Great Depression of
1929-1933, for example, was a deflationary depression,
in which deflation was a precursor to depression.
Based on how economists have applied these labels
in the past, we may conclude that a recession is a
moderate decline in total production lasting from
a few months to two years. A depression is a decline
in total production that is too deep or prolonged
to be labeled merely a recession. As you can see,
these terms are quantitative yet utterly imprecise.
They cannot be made precise, either, despite misguided
attempts to do so.
As for whether deflation is a precursor to depression,
our research shows that the largest stock-market collapses
do not follow lengthy periods of market deterioration;
instead they appear quite suddenly, after long periods
of rising stock prices and economic expansion. So
a deflationary depression begins with the seemingly
unpredictable reversal of a persistent and often rapidly
rising stock market. The abrupt change from increasing
optimism to increasing pessimism initiates the deflationary
depression. However, due to their backward-looking
measures, most economists will endure several months,
even years of deflation before declaring a depression.
For more on deflation, Download Robert Prechter's FREE 60-page eBook, The Guide to Understanding Deflation.
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