Deflation: Meaning, Causes & Effects

When prices fall, it’s often regarded as a positive development—at least when it comes to your favorite shopping sites. When prices fall across the entire economy, this is referred to as deflation, and it’s a whole different ballgame. Deflation is harmful for the economy and your savings. Here’s all you need to know about deflation.

Definition of Deflation

Deflation occurs when consumer and asset prices fall over time while buying power rises. Essentially, with the same amount of money you have today, you can buy more goods or services tomorrow. This is the inverse of inflation, which is the progressive rise in prices throughout the economy.

While deflation may appear to be a beneficial thing, it can indicate an imminent recession and difficult economic circumstances. When individuals believe that prices are about to fall, they put off purchases in the hopes of getting them cheaper later. Reduced spending, on the other hand, means less income for producers, which can lead to unemployment and higher interest rates.

This negative feedback loop leads to increased unemployment, lower pricing, and decreased expenditure. In other words, deflation breeds more deflation. Deflationary eras have historically been associated with significant economic downturns.

How Is Deflation Calculated?

Deflation is quantified using economic indicators such as the consumer price index (CPI), which tracks and publishes monthly changes in the prices of a collection of widely purchased products and services.

When aggregate prices measured by the CPI are lower in one period than they were in the previous period, the economy is experiencing deflation. In contrast, when prices rise collectively, the economy experiences inflation.

What is the Cause of Deflation?

Deflation can be caused by either a decline in demand or an increase in supply. Each is linked to the basic economic connection of supply and demand. If supply does not change, a decrease in aggregate demand leads to a decrease in the price of products and services.

Monetary policy can cause a reduction in aggregate demand. Rising interest rates may cause people to save their money rather than spend it, and may discourage borrowing. When people spend less, there is less demand for goods and services.

Declining confidence can also lead to reduction in aggregate demand. Adverse economic occurrences, such as a global epidemic, may reduce overall demand. People who are concerned about the economy or unemployment may spend less in order to save more.

Because of more competition, higher aggregate supply may force producers to cut their prices. This increase in aggregate supply could be the result of lower production costs: if it costs less to produce items, companies can produce more of them for the same price. As a result, there may be more supply than demand, resulting in reduced pricing.

The Effects of Inflation

Although lower prices for products and services may appear beneficial, they can have a significant negative impact on the economy:

Unemployment. As prices fall, so do firm profits, and some businesses may cut costs by laying off people.
Debt. During periods of deflation, interest rates tend to rise, making debt more expensive. As a result, both consumers and corporations frequently reduce their expenditures.
Spiral of deflation. Each overlapping piece of deflation causes a domino effect. Lower output may result from falling prices. Lower remuneration may result from decreased output. Lower compensation may lead to a decrease in demand. Furthermore, a decline in demand may result in ever-lower prices. And so forth. This can exacerbate a negative economic condition.

Why Is Deflation Worse Than Inflation?

Inflation occurs when prices rise and the purchasing power of the dollar falls.

While inflation reduces the purchasing power of your currency, it also reduces the value of debt, so borrowers continue to borrow and debtors continue to pay their bills. Modest inflation is a regular part of the economic cycle—the economy typically experiences 1% to 3% annual inflation—and a small amount is often regarded as a sign of strong economic growth.

To some extent, customers can also protect themselves against inflation. Investing, for example, can help your wages rise faster than inflation, allowing you to keep and grow your spending power.

While rising prices may appear to be worse than falling prices, deflation is often less desirable and is related with economic contractions and recessions. A deflationary spiral might transform difficult economic conditions into recessions, and finally depressions.

Protecting against deflation is also more difficult than protecting against inflation. Unlike with inflation, debt becomes more expensive with deflation, causing people and organizations to avoid taking on new debt in order to pay off their existing, increasingly expensive loans.

During periods of deflation, the greatest place for people’s money to be is in cash investments, which earn little, if any, returns. When there is deflation, other sorts of investments, such as stocks, corporate bonds, and real estate investments, are riskier since enterprises can experience very tough times or fail totally.

Deflation Control

The government has a few initiatives in place to combat deflation:

Increase the money supply. To expand the quantity of money, the Federal Reserve can buy back treasury assets. With more supply, each dollar becomes less valuable, encouraging individuals to spend and driving up costs.
Make borrowing more convenient. The Fed may push banks to increase credit availability or cut interest rates so that customers can borrow more. Banks can lend out more money if the Fed decreases the reserve rate, which is the amount of cash that commercial banks must keep on hand. This encourages spending and contributes to price increases.
Control fiscal policy. Government spending increases and tax cuts can improve aggregate demand and disposable income, resulting in increased spending and higher pricing.

How Deflation Has Influenced History

Overall, the United States has experienced inflation rather than deflation. However, deflation has shaped the economics of the United States and other countries at times:

The American Great Depression

Deflation accelerated one of the most difficult economic times in US history, the Great Depression. Although it began as a recession in 1929, gradually declining demand for products and services prompted prices to fall dramatically, resulting in the failure of many businesses and soaring unemployment rates. The wholesale price index plunged 33% between the summer of 1929 and early 1933, and unemployment reached 20%.

Price deflation caused by the Great Depression occurred in almost every other industrialized country on the planet. In the United States, output did not resume its prior long-term trend course until 1942.

Deflation in Japan

Since the mid-1990s, Japan has been experiencing mild deflation. In reality, with the exception of a brief period prior to the 2007-08 global financial crisis, the Japanese CPI has virtually always been somewhat negative since 1998.

Some observers attribute this problem to Japan’s output gap—the discrepancy between actual and potential output in the Japanese economy. Others argue that the problem is a lack of monetary easing.

In any case, the Bank of Japan is now pursuing a negative interest rate policy, which is a monetary policy that penalizes people for hoarding money in a bid to battle deflation.

Great Depression

Deflation was a major concern during the United States’ recession, which lasted from late 2007 to mid-2009. Commodity prices declined, making it more difficult for debtors to repay loans. The stock market was down, unemployment was increasing, and property prices plummeted.

Economists were feared that deflation would cause a severe economic downturn, but this did not occur. According to one analysis published in the American Journal of Macroeconomics, the financial crisis at the start of the period managed to keep inflation stable.

Because lending rates were so high at the start of the recession, several businesses were unable to reduce prices, which may have prevented widespread deflation.

An Overview of Deflation vs. Disinflation

Although they may sound similar, deflation and disinflation are not the same thing. Deflation is a drop in overall price levels across an economy, whereas disinflation occurs when price inflation stops momentarily. Deflation, the inverse of inflation, is primarily produced by changes in supply and demand.

Disinflation, on the other hand, depicts the change in the inflation rate over time. The rate of inflation is decreasing over time, yet it remains positive.

Deflation

Deflation is the economic word meaning a decline in the price of goods and services. It dampens economic growth. It usually occurs during periods of economic uncertainty, when demand for products and services is lower and unemployment is higher. When prices decline, inflation falls below 0%.

The consumer price index (CPI) can be used to calculate deflation (and inflation) rates. This index tracks changes in the prices of a variety of goods and services. They can also be measured using the GDP deflator, which quantifies the rate of price inflation. Deflation can be caused by a variety of causes, including a decrease in the money supply, government spending, consumer spending, and corporate investment.

Price decreases might also result from increased business productivity. When a corporation employs more advanced technology in its manufacturing process, it may become more efficient, lowering its expenses. These cost savings could subsequently be passed on to the consumer in the form of lower prices.

An Example

Take, for example, mobile phones. Because of technological advancements, cellphone prices have declined dramatically since the 1980s. This has allowed supply to grow faster than money supply or demand for telephones.

Bonds, on the other hand, can do well in times of deflation. More investors are attracted to high-quality assets that provide a more secure investment vehicle. It, on the other hand, can have a negative impact on the stock market. A reduction in prices—and thus supply and demand—will harm company profitability, causing share value to erode.

To combat deflation, a central bank will intervene and implement an expansionary monetary policy. It lowers interest rates and expands the economy’s money supply. As a result, demand for goods and services rises. Lower interest rates imply increased consumer spending power. More spending leads to price inflation and, as a result, increased demand for goods and services. Increased pricing results in increased earnings for enterprises.

Disinflation

Disinflation happens when price inflation temporarily slows. The Federal Reserve of the United States uses this word to indicate a period of declining inflation. In contrast to deflation, this is not detrimental to the economy because the inflation rate is reduced marginally over a short period of time.

Disinflation, as opposed to inflation and deflation, is a shift in the rate of inflation. Prices do not fall during periods of disinflation, and it does not indicate a slowing of the economy. While a negative growth rate, such as -2%, denotes deflation, a change in the inflation rate from one year to the next implies disinflation. So disinflation would be defined as a 4% drop from one year to the next.

Disinflation isn’t always harmful to the stock market, as it might be during deflationary periods. In reality, when the inflation rate falls, equities can perform well.

Disinflation is induced by a variety of circumstances. Disinflation can occur as a result of a recession or a contraction in the business cycle. It could also be induced by a central bank tightening its monetary policies. When this occurs, the government may start selling some of its securities, reducing its money supply.

Has the UK Ever Had Deflation?

Following the inflation of World War I, the United Kingdom suffered deflation (falling prices) in the 1920s and early 1930s.

Is Deflation a Bad Thing?

Deflation is typically associated with a declining economy. Economists are concerned about deflation because dropping prices lead to lower consumer spending, which is a key component of economic growth. Companies respond to lowering pricing by delaying production, which results in layoffs and compensation cuts.

What Was The Worst Deflation in History?

The earliest and most severe was the 1818-1821 downturn, when agricultural commodity prices fell by about 50%. A credit contraction triggered by the English financial crisis pulled specie out of the United States. The lending of the Bank of the United States was likewise reduced.

What Should I Invest In During Deflation?

HISAs
Sectors of defense.
Stocks that pay dividends.
Bonds of investment grade (IG).

In Conclusion

Deflation is the overall decrease in the cost of goods and services in an economy. While a minor fall in prices may encourage consumer spending, widespread deflation can discourage expenditure, leading to even more deflation and economic downturns.

Fortunately, deflation is rare, and when it does occur, governments and central banks have measures to mitigate its damage.