Is Deflation a possibility in India?

Indian people are all too familiar with rising prices. Over the past few years, inflation had been steadily climbing upwards making almost everything expensive. It’s a relief to see inflation begin to cool off recently. But that raises a question - is deflation a possibility for India?

Deflation is the opposite of inflation. During inflation prices go up. During deflation prices come down. Things start becoming cheaper! Now this may sound very good, but economists try to avoid deflation like plague. There are very good reasons too. Consider a classic deflation scenario, in which prices are coming down:
Customers postpone purchase: Customers tend to postpone further purchases - especially big ticket purchases, apart from basic necessities (a good example of this is the real estate sector in India - most customers are waiting for prices to fall further).
Aggregate demand falls: As more and more customers postpone purchases, the aggregate demand goes down. When this happens, two things happen simultaneously: Price cuts and Production cuts.
Prices cuts: Some producers reduce prices to spur demand. As producers reduce prices, it reinforces the customer mentality that prices will go down further. Thus they postpone purchase further!
Production cuts: Some producers start cutting down on production. As producers cut down production, it results in layoffs or pay cuts. Both scenarios lead to a fall in aggregate demand.
Cycle repeats: As aggregate demand falls further, producers again respond in the two ways above... and thus a vicious cycle starts.

As expected, the fallout of deflation is that economic activity slows down, unemployment increases, and stock markets languish. History has shown that once deflation has set in, it is very difficult to reverse . A classic example is Japan , whose economy has been severely hit by deflation in the recent past.

So, is deflation a threat to the Indian economy? The Indian economy is already seeing deflationary pressures in some sectors (like real estate and to an extent automobile). A full-fledged economic deflation, though, is a remote possibility. However, if the global financial crisis drags on for another six months, then the Indian economy will face a very real threat of deflation. Let us hope things don’t come to that!




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This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.