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Friday, 22 April 2011

Deflation

Deflation is a sustained absolute annual decrease in the general price level of goods and services.

Deflation happens when the annual inflation rate falls below zero percent (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 over time; conversely, annual deflation increases the real value of money in a national or regional economy over a period of 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 fundamental model of accounting implementing IFRS, is the best practice: A low level of inflation (best practice is currently regarded as 2% annual inflation) to limit the erosion of real value in money and other monetary items; IFRS for the correct valuation of variable real value non-monetary items and, thirdly, financial capital maintenance in units of constant purchasing power (CIPPA)  as authorized in IFRS for automatically maintaining the existing constant real values of existing constant real value non-monetary items constant for an indefinite period of time during low inflation and deflation in all entities that at least break even without the requirement for extra capital or extra retained profits simply to maintain the existing constant real value of existing constant real value non-monetary items (e.g. equity) constant.

Net monetary losses and gains are calculated and accounted in the income statement during low inflation and deflation when CIPPA is implemented: basically, the cost of inflation is accounted as a loss and deducted from profit before tax. Reducing the holding of 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 before the event to know what the inflation rate will be during any future period. It is possible to invest money in some economies in inflation-proof investments: the interest paid is stated at the start of the contract to be equal to the inflation rate plus 2 or 3 or 4 per cent to give a real return on the investment.

Nicolaas Smith

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