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Friday, 11 May 2012

Deflation

Deflation



Deflation is a sustained absolute annual decrease in the general price level of goods and services. Deflation only occurs when the annual inflation rate falls below zero per cent (a negative annual inflation rate), resulting in an increase in the real value of money and all other monetary items. Deflation allows one to buy more goods with the same amount of money. This should not be confused with disinflation, a slow–down in the annual inflation rate (i.e., when annual inflation decreases, but still remains positive). Disinflation is a decrease in the annual rate of increase in the general price level. Annual inflation erodes the real value of money and other monetary items over time; conversely, annual deflation increases the real value of money and other monetary items in a national or regional economy over time.



Inflation and deflation are both undesirable economic processes. As far as the understanding of inflation and deflation allows us at the moment, it can be stated that whatever level of deflation – however low – is to be avoided completely. A low level of inflation in an economy with financial capital maintenance in units of constant purchasing power (CIPPA) as the basic model of accounting implementing IFRS in terms of a Daily CPI or monetized daily indexed unit of account would be the best practice. A low level of inflation (best practice is currently considered to be two per cent annual inflation) to limit the erosion of real value in money and other monetary items. Inflation-adjusting the total money supply in terms of a daily index rate with complete co-ordination would remove the total cost of inflation (not actual inflation) from the economy.  IFRS, excluding the stable measuring unit assumption, for the correct daily valuation of variable items and, thirdly, financial capital maintenance in units of constant purchasing power (CIPPA) as authorized in IFRS in terms of a daily index or other daily rate for automatically maintaining the existing constant real value of owners´ equity constant for an indefinite period of time in all entities that at least break even in real value during inflation and deflation – ceteris paribus – whether they own any revaluable fixed assets or not and without the requirement of extra capital or extra retained profits simply to maintain the existing constant real value of existing constant items (e.g., equity) constant.



Net monetary losses and gains would be calculated and accounted in the income statement during inflation and deflation when CIPPA is implemented for all monetary items not inflation-adjusted on a daily basis. The cost of inflation would be accounted as a loss and deducted from profit before tax and the gain from inflation would be accounted as a gain and added to profit before tax. Reducing the holding of net monetary items (cash and other monetary items) over time would reduce the net monetary loss to a minimum during low inflation. Entities do their best to compensate for the net monetary loss from holding cash and other monetary items by trying to invest them at rates higher than the expected inflation rate. Obviously, it is not possible beforehand to know what the inflation rate will be during any future period. Capital inflation-indexed bonds overcome this problem (2012).

Nicolaas Smith

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