I guess for those people in our age group, we know inflation far more than deflation. Inflation is where my Kopi-O increased from 60 cents to 80 cents meaning that my daily fixation increased by 33.33% over the last two years. In that sense, inflation is definitely a bad thing. But this is something we have been used to as long as we can remember. I heard of my teachers mentioning 10 cents Char Kway Teow but that’s prehistoric era. So, what is deflation? Deflation is when I borrow $2 from Mr X, well $2 may get you a plate of wanton noodles. So 1 year later I returned him the $2. But then your $2 can get you 2 plates of wanton noodles for eg, this is deflation. Seems wonderful isn’t it? Your money grows in your wallet without you doing anything.

Well then, someone needs to be stupid enough such that they part with their money for you to keep. With deflation, why will the banks even bother to loan anyone money given that their money will grow on its own. Most economists believe sustained deflation is far more damaging than an equivalent inflation [Citations Needed]. Actually inflation helps in economic growth. A study by Milken Institute argues that economic growth is maximized at an inflation rate of between 1.6% and 3% per year [1]. So, who will be foolish enough to be a nett lender of money unless the cost of lending money is covered and compensated by an increase in real interest rates. So what does deflation do? Take a factory for eg, the faster it sells its goods, the lower is the real profits. There is no incentives to produce more and sell more faster. Factories will tend to cut down on employment. Workers on the other hand will be least inclined to spend, given that the longer you delay spending, the more you will be able to buy as deflation kicks in. The result will be a decrease in consumption and all economical activities. It is an extremely vicious cycle at work.

In the beginning of the year, there are genuine concerns that deflation may set in. These has been more or less assuaged as my Kopi-O grows more expensive. A definite indication of inflation at work. To get to Inflation and Deflation, lets have some definitions first, courtesy of [2]

* M1: M1 includes funds that are readily accessible for spending. M1 consists of: (1) currency outside Federal Reserve Banks, and the vaults of depository institutions; (2) traveler’s checks of nonbank issuers; (3) demand deposits; and (4) other checkable deposits (OCDs), which consist primarily of negotiable order of withdrawal (NOW) accounts at depository institutions and credit union share draft accounts. Bank reserves are not included in M1.

* M2: Equals M1 + savings deposits, time deposits less than $100,000 and money market deposit accounts for individuals. M2 represents money and “close substitutes” for money. M2 is a broader classification of money than M1. Economists use M2 when looking to quantify the amount of money in circulation and trying to explain different economic monetary conditions. M2 is a key economic indicator used to forecast inflation.

Why not M3? Well, reason was that M3 statistics was stopped as in early 2006. There is quite a lot of conspiracy theories over this [3]. Side stepping the conspiracies to go back to the topic proper. Lets look at the M2 graph [4].

M2 Graph

There is a lot of allegations on the overtime work by USA currency notes printers. But it isn’t reflected here in the graph above. As we can see that the M2 money supply has been basically flat, growing by only 1.8% over the last ten months. We next need to consider the differences between M1 and M2. Looking at M1 below [5]:

M1 Graph

M1 does show some correlationship with M2. But we need to look at another factor, the multiplier. A multiplier is calculated simply by dividing either M1 or M2 by the monetary base. In this way, the impact of monetary policy can be measured. For eg a multiplier of 2 indicates that for every dollar that the Fed pumps in, they get the effect of two dollars. Lets take a look at M1 Multiplier [6]

M1 Multiplier

What does it mean with M1 Multiplier going below 1? This means that for every dollar the Fed prints out, its effect is less than a dollar, in fact dropping to less than 90 cents. Economic activity is measured by the product of the velocity of money and the amount of money in circulation and this has basically collapsed [7].

Economic Activity

We are staring right in the eyes of Deflation, contraction of money supply as well as credit and diminishing velocity of money. Exactly 1 year passed, 18 Oct 2008, Wall Street Journal Blog, Deflation, Ben Bernanke and the Famous Helicopter, the Deflation threat remains as real as ever.

Will I get to see my Kopi-O dropped back to 60 cents? I wonder……..

References

[1] James R. Barth, Tong Li, Sangeetha Malaiyandi, Donald McCarthy, Triphon Phumiwasana and Glenn Yago, Oct 2005, 2005 Capital Access Index Securitization in Financing Economic Activities ,Best Markets for Entrepreneurial Finance,

[2] Money Supply, Wikipedia, the free encyclopedia, http://en.wikipedia.org/wiki/Money_supply, Accessed 18 Oct 2009.

[3] JOHN WILLIAMS’ SHADOW GOVERNMENT STATISTICS, Issue Number 13B (Supplement to Regular November Edition), 23 Nov 2005.

[4] Economic Research, Federal Reserve Bank of St. Louis., Series: M2, M2 Money Stock, http://research.stlouisfed.org/fred2/series/M2, 16 Oct 2009, Accessed 18 Oct 2009.

[5] Economic Research, Federal Reserve Bank of St. Louis., Series: Fred Graph, http://research.stlouisfed.org/fred2/graph/?s[1][id]=M1, 16 Oct 2009, Accessed 18 Oct 2009.

[6] Economic Research, Federal Reserve Bank of St. Louis., Series: http://research.stlouisfed.org/fred2/series/MULT, http://research.stlouisfed.org/fred2/series/MULT, 16 Oct 2009, Accessed 18 Oct 2009.

[7] John B. Lounsbury Ph.D., CFP Deflation Looms and Doubts About Growth,
John Lounsbury’s Instablog, http://seekingalpha.com/instablog/98115-john-lounsbury/27187-deflation-looms-and-doubts-about-growth, 11 Sep 2009, Accessed 18 Oct 2009.