Why Don't Prices Decline During A Recession?

[Q:]When there is an 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) and particularly for goods and services that cannot rapidly meet the increased demand such as housing in urban centers (relatively fixed supply), advanced education (takes time to expand/build new schools), but not cars because automotive plants can gear up pretty quickly.

First, do you agree with this and if not, how do you see it?

Second, when there is an economic contraction, supply initially outpaces demand. However prices for most goods and services don't go down, and neither do wages.

My main question is why don't prices go down for goods and services? I expect for wages, it's just stickiness from the corporate/human culture... people don't like to give pay cuts... managers tend to lay off before they give pay cuts (though I've seen exceptions). Why don't prices go down for most goods and services?

[A:] Great question! Your analysis is spot on. Now on to your question:

In my article titled Why Does Money Have Value we saw that changes in the level of prices (inflation) was 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.

From my article titled A Beginner's Guide to Economic Indicators we saw that measures of inflation such as the Implicit Price Deflator for GDP are procyclical coincident economics 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 busts, but why is the inflation rate still positive in recessions?

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. (To learn about these definitions, see How much is the per capita money supply in the U.S.?). 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.