Avoiding the deflationary spiral

Gary Rabbior is the president of the Canadian Foundation for Economic Education. This is the third of a six-part series on understanding how the economy works and why it matters to investors.

In the last article, , we used our Auction Block game to show that if we increase the amount of money in an economy, without producing more goods and services to buy, we get inflation. Now let's use our Auction Block game analogy to make another point.

Suppose in Room #3 we have another game where we double the quantity of money again over that used in Room #1. But this time, we won't double the players' money equally. In Room #1 each of three players had $10,000 and there was $30,000 in the game. In Room #2 each of three players had $20,000 and there was $60,000 in the game. Now, we give one player $20,000, one player $10,000, and one player $30,000. The quantity of money in the game has doubled from that in Room #1 (i.e., from $30,000 to $60,000), but each player now has a different amount of money.

Cat:e528746c-3414-401a-b14b-50247e3bdf01Forum:2d13dc33-9921-4d4a-815f-e809277631e4

As with the game in Room #2, as this game begins the amount the players are generally willing to bid will likely rise above the prices bid in the game in Room #1. Why - because in this game, two players have considerably more money to spend ($20,000 and $30,000 rather than $10,000).

Once again, though, with no additional things to buy, this added spending will only serve to generate higher prices. However, as prices rise in this game we can see that players will be affected differently. If prices double in this game, the player with $30,000 will end up better off than if he/she was playing in the game in Room #1 because that player's income has more than doubled. This player will find it easier to pay the higher prices in Room #3.

The player with $20,000 may find that there is no difference from the players in Room #2. Prices in Room #3 double over those in the game in Room #1 but, at the same time, this player's income has also doubled. The player with $20,000 rather than $10,000 is no better off, and no worse off, than those playing in Rooms #1 and #2.

However, the player with $10,000 will be in a very different position. As prices rise in the game in Room #3, that player will have a hard time paying the higher prices and, therefore, this player will end up acquiring less than the other players. This player will also end up with less than players in Rooms #1 and #2.

The game in Room #3 helps show how inflation can hurt certain people. If your income rises faster than prices (inflation), you can become better off. However, if prices rise but a person's income can't keep pace, he or she can end up worse off.

That's one good reason why the Bank of Canada tries to keep prices in our economy stable and under control since there are many people who may struggle to keep pace with inflation - and, the higher the rate of inflation, the higher the number of people who will have trouble keeping pace.

Deflation

But now let's move on to the game in Room #4. In this game, instead of doubling the amount of money players receive over that in Room #1, we will cut the amount of money in half to $5,000 each. Let's see what impact that will have.

Are the players in Room #4, who have 50 per cent less money, less well off, as a group, than those in Room #1? With all the players in this game having less money, the likelihood is that players will bid lower prices for the items on the Auction Block and items will be purchased at lower prices than those in the game in Room #1.

Each player in this game may end up being as well off as those in games in Rooms #1 and #2. Why? Because lower prices and a lower average price level make it possible for them to acquire the same "stuff" - and acquire the same level of real wealth. The lower incomes lead to bidding lower prices.

If we compare total spending of the game in Room #1 with that of the game in Room #4, we will see that the total level of spending in Room #4 is lower - probably by half. What we would say here is that nominal spending was lower than the game in Room #4. This doesn't mean that people playing the game in Room #4 are worse off. The players are simply spending less money to acquire the same items at lower prices. The goods and services are being exchanged at a lower average price level.

Now lower prices may sound like a good thing. Maybe you're thinking that falling prices in our economy would help to make people better off. But it is important to recognize that "deflation" (falling average price level) is not necessarily a good thing for an economy.

Why is that? The reason is because an economy will usually experience significant hardship as the average price level falls. When do prices, on average, fall? That happens when demand is low - when people aren't spending - inventories are growing - and so on. This can lead producers to lay people off. Some may even shut down or go bankrupt. Furthermore, if prices, on average, are falling, then people may hold off spending hoping to be able to pay lower prices. This can lead to more of a decline in spending, more layoffs, more unemployment - and so on.

So deflation can start to feed on itself - and can lead to considerable hardship for many people. That is why the Bank of Canada doesn't try to achieve deflation. A certain amount of inflation is seen as part of a growing healthy economy. The Bank of Canada has set a target of 2% as a rate of inflation consistent with a healthy economy.

The key point to note is that more money and more spending in an economy do not necessarily mean more goods and services are purchased and people are better off. The level of spending has to be considered along with available output and the changes in prices. It is therefore important that we use real, rather than nominal, information when comparing one year in our economy with another year.

Consider an unrealistic example that makes the math simple. Suppose one year Canada's Gross Domestic Product (GDP) - which measures the value of goods and services produced in Canada in one year - was $1,000 (it is actually more in the range of $1.5-trillion). Suppose the next year it was $1,020. Did the economy grow? It looks like it but you don't really know unless we know how much of that increase was due to higher prices. For example, if inflation was 2 per cent, then that means the additional $20 was only due to higher prices. There was no more output actually produced. Nominal GDP would be $1,020 but real GDP, taking out the impact of higher prices, would be $1,000 - and would show that no growth would have occurred.

Now, let's move on to our final game - the one going on in Room #5.

Suppose, in this game, we add some new items to our game so that the players are playing with a different game board than the players in the other rooms. We'll also add some new money to the game, over and above the amount given to those in Room #1. (For the moment, we won't state just how much new money.) What is the impact of the new items and the new money in the game going on in this room?

The additional items represent increased real output that is now available to the players in the game. At least some of the additional money added to the game can be used to buy these new items. As a result, it is now possible for the players in this game to become better off in real terms because there are new things to acquire. Whether or not prices rise will depend on how the increase in money and spending in this room compares with the increase in the number and value of real things there are to buy.

By now you should be able to conclude that "too much" new money will lead to "inflation" - "too little" new money can lead to deflation or leave items unpurchased. Just "the right" amount of money should enable all players to become better off and keep prices in the game relatively stable.

If you can understand what is going on in each of the five games - and understand the relationship between the quantity of money and the quantity of output available to buy, then you are beginning to get a real grasp on the relationship between money, output, and prices in the economy.

In the games in Rooms #2 and #3, more money is added, but there is nothing new to buy. The new money only serves to push up prices and, in Room #3, some players were better off than others since they received more money. In game #4, there was less money but the same items to buy - and the average price level was lower. In the game in Room #5, there are new items available and more money was added. The added money could acquire new things so the game could have more money without inflation occurring.

So, what has the Auction Block analogy shown us? First of all, simply adding more money to an economy through its financial system, and encouraging more spending, won't necessarily make people better off. For people to be better off, the economy will have to produce more.

If the economy produces more output, then more money can be added to the economy so that people can purchase the new output. This can make people better off - hopefully everyone and not just some.

If there is more output, but no more money, you may think prices will fall to enable the new output to be sold. But a funny thing about prices - they don't tend to fall quickly or easily. They are said to be "sticky downwards." If prices don't fall, and not enough money is added to the economy, then output will remain unsold - inventories will build up - employers will cut back production - people will be laid off - and the economy may turn down. That is why it is important to make sure there is enough money in the system to support new purchases if the economy grows produces more output. Otherwise, growth in the economy can be stifled.

This helps explain why managing the amount of money in the economy is important - and challenging. Getting the amount of money just right isn't easy. But, over the years, and with lots of experience, the Bank of Canada is getting pretty good at it. Much of the recent economic turmoil has been global and has arisen from events in the U.S. - things outside the Bank of Canada's control. In the next part of this series, we will look more closely at how the Bank of Canada tries to generate the "right" monetary conditions for Canada's economy.