Why Deflation Doesn't Happen During a Recession

The Link Between The Business Cycle and Inflation

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When there is economic expansion, demand seems to outpace supply, particularly for goods and services that take time and major capital to increase supply. As a result, prices generally rise (or there is at least price pressure), particularly for goods and services that cannot rapidly meet the increased demand, such as housing in urban centers (relatively fixed supply), and advanced education (takes time to expand/build new schools). This doesn't apply to cars because automotive plants can gear up pretty quickly.

Conversely, when there is an economic contraction (i.e. recession), supply initially outpaces demand. This would suggest that there would be downward pressure on prices, but prices for most goods and services don't go down and neither do wages. Why do prices and wages appear to be "sticky" in a downward direction?

For wages, corporate/human culture offer up a simple explanation: people do not like to give pay cuts... managers tend to lay off before they give pay cuts (though there exist some exceptions). That said, this doesn't explain why prices don't go down for most goods and services. In Why Does Money Have Value, we saw that changes in the level of prices (inflation) were due to a combination of the following four factors:

  1. The supply of money goes up.
  2. The supply of goods goes down.
  3. Demand for money goes down.
  4. Demand for goods goes up.

In a boom, we would expect that the demand for goods to rise faster than the supply. All else being equal, we would expect factor 4 to outweigh factor 2 and the level of prices to rise. Since deflation is the opposite of inflation, deflation is due to a combination of the following four factors:

  1. The supply of money goes down.
  2. The supply of goods goes up.
  3. Demand for money goes up.
  4. Demand for goods goes down.

We would expect the demand for goods to decline faster than the supply, so factor 4 should outweigh factor 2, so all else being equal we should expect the level of prices to fall.

In A Beginner's Guide to Economic Indicators we saw that measures of inflation such as the Implicit Price Deflator for GDP are pro-cyclical coincident economic indicators, so the inflation rate is high during booms and low during recessions. The information above shows that the inflation rate should be higher in booms than in bursts, but why is the inflation rate still positive in recessions?

Different Situations, Different Results

The answer is that all else is not equal. The money supply is constantly expanding, so the economy has a consistent inflationary pressure given by factor 1. The Federal Reserve has a table listing the M1, M2, and M3 money supply. From Recession? Depression? we saw that during the worst recession America has experienced since World War II, from November 1973 to March 1975, real GDP fell by 4.9 percent.

This would have caused deflation, except that the money supply rose rapidly during this period, with the seasonally adjusted M2 rising 16.5% and the seasonally adjusted M3 rising 24.4%. Data from Economagic shows that the Consumer Price Index rose 14.68% during this severe recession.

A recessionary period with a high inflation rate is known as stagflation, a concept made famous by Milton Friedman. While inflation rates are generally lower during recessions, we can still experience high levels of inflation through the growth of the money supply.

So the key point here is that while the inflation rate rises during a boom and falls during a recession, it generally does not go below zero due to a consistently increasing money supply. 

In addition, there may be consumer psychology-related factors that prevent prices from decreasing during a recession- more specifically, firms may be reluctant to decrease prices if they feel like customers will get upset when they increase prices back to their original levels at a later point in time.

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Moffatt, Mike. "Why Deflation Doesn't Happen During a Recession." ThoughtCo, Aug. 17, 2021, thoughtco.com/why-prices-dont-drop-during-a-recession-1146306. Moffatt, Mike. (2021, August 17). Why Deflation Doesn't Happen During a Recession. Retrieved from https://www.thoughtco.com/why-prices-dont-drop-during-a-recession-1146306 Moffatt, Mike. "Why Deflation Doesn't Happen During a Recession." ThoughtCo. https://www.thoughtco.com/why-prices-dont-drop-during-a-recession-1146306 (accessed February 4, 2023).