Key Points

  • Deflation is a decline in prices, which increases the purchasing power of money. This causes the price of goods and services to fall and leads to an increase in savings.

  • While deflation is often considered a good thing, persistent deflation can have negative effects on an economy. If not managed properly, deflation can increase unemployment and slow economic growth.

What is deflation?

Deflation is a decrease in the prices of goods and services in an economy. In fact, deflation is often viewed as a good thing because it gives you more bang for your buck. However, in some cases, it can also have a negative impact on the economy.

Problematic deflation is rare. In general, our financial system is more vulnerable to inflation than deflation. However, if your country ends up facing persistent deflation, it is helpful to understand its negative effects.

Let’s take a closer look at the common causes and potential effects of deflation.

Common causes of deflation

Total demand decreases

Aggregate demand represents the broad demand for goods and services. When individuals and businesses spend less, demand falls, typically leading to lower prices.

Increased supply

Oversupply can also cause prices to fall if companies produce more of a product than people want to buy. This can happen, for example, if new technology reduces production costs and makes production more efficient.

Strong Currency

When a country's currency is strong, that currency can buy more foreign goods, resulting in cheaper imports and lower prices for domestic goods. Also, if a country's currency is strong, it can make that country's exports more expensive to other countries, reducing demand for its exported goods and services.

Deflation vs Inflation

Although both deflation and inflation are related to overall price changes, they have different causes, effects, and impacts on the economy.

definition

Deflation is when the overall price of goods and services falls, while inflation is when prices rise. Therefore, deflation increases the purchasing power of money, while inflation does the opposite.

Cause

As mentioned earlier, deflation can result from a decrease in aggregate demand, an increase in supply, or new technologies.

Conversely, an increase in aggregate demand, an increase in production costs, and an expansionary monetary policy may cause inflation. In practice, it is usually a combination of factors.

Influence

During periods of deflation, prices gradually fall and the local currency strengthens, which encourages consumers to save more and postpone purchases. Lower demand can eventually lead to economic stagnation and rising unemployment.

On the other hand, inflation reduces the value of money and creates uncertainty, encouraging people to spend more before prices rise further.

How to fight deflation

Both inflation and deflation can cause problems, although inflation is often considered more worrisome. Japan is an example of a country that has experienced a small but persistent period of deflation. Generally speaking, central banks aim for lower annual inflation rates (usually around 2%) to keep the economy buoyant.

To combat deflation, governments and central banks use fiscal policy and monetary policy.

Monetary Policy

Central banks can lower interest rates to encourage borrowing and spending. Lower interest rates make borrowing less expensive for businesses and consumers, which stimulates economic activity. Another option is to implement quantitative easing (QE), which increases the money supply and encourages spending.

Fiscal policy

Fiscal policy measures may include increased government spending to boost demand in the economy. Tax cuts may also be implemented to increase disposable income for consumers and businesses, encouraging them to spend more and invest more.

Advantages of Deflation

Goods are cheaper: During deflation, the value of money increases, the prices of goods fall, and the standard of living improves.

Reduced business expenses: The cost of materials required for production decreases, benefiting the business.

Increased Savings: As the value of money increases, people may be more inclined to save rather than spend.

Disadvantages of Deflation

Reduced spending: Deflation may cause consumers to postpone purchases in the hope that prices will fall further. This reduces demand for goods and services, which may lead to slower economic growth.

Increased liabilities: During deflation, the value of debt tends to increase, making it more difficult for borrowers to repay their loans.

Rising unemployment: Reduced consumer spending can cause businesses to cut costs, often through large-scale layoffs.

Conclusion

Deflation is a decline in the overall price level. While deflation can make goods cheaper and encourage saving, it can also lead to reduced consumer spending, increased debt, and higher unemployment.

Further reading

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