Key points to remember

  • Deflation describes a decrease in prices, which can increase the purchasing power of your money. This can result in more affordable goods and services and allow for more savings.

  • Although often seen as a good thing, persistent deflation can have a negative impact on the economy. If not managed well, deflation can increase unemployment and slow economic growth.

What is deflation?

Deflation describes a decrease in the price of goods and services in an economy. In practice, deflation is generally seen as a good thing, as it allows people to get more value for their money. But in some cases, it can also have negative effects on the economy.

Episodes of problematic deflation are rare. Overall, our financial system is more sensitive to inflation than to deflation. However, if you do end up facing persistent deflation in the country you live in, it is useful to be aware of some of its negative effects.

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

Common Causes of Deflation

Decrease in general demand

General demand represents the total demand for goods and services. When individuals and businesses spend less money, demand decreases, often leading to lower prices.

Increase in supply

If companies produce more than people want to buy, the excess supply can also lead to lower prices. For example, this can happen because of new technology that makes production cheaper and more efficient.

Hard currency

When a country's currency is strong, it allows more foreign goods to be purchased, leading to cheaper imports and lower prices for domestic goods. In addition, a strong currency can make a country's exports more expensive for other countries, reducing demand for exported goods and services.

Deflation vs. inflation

Although both deflation and inflation are related to changes in the general price of things, they have different causes, effects, and implications for the economy.

Definition

While deflation refers to a decrease in the general price of goods and services, inflation refers to an increase in prices. Thus, deflation increases the purchasing power of money, while inflation does the opposite.

Causes

As we have learned, deflation can be caused by a decrease in overall demand, an increase in supply, or new technologies.

In contrast, inflation can occur due to an increase in general demand, higher production costs, and expansionary monetary policy. In practice, it is usually a combination of factors.

Effects

In times of deflation, the gradual decline in prices and the strengthening of the local currency encourage consumers to grow their savings and delay purchases. The decline in demand could eventually lead to economic stagnation and higher unemployment rates.

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?

Although inflation is generally seen as more of a concern, both inflation and deflation can cause problems. Japan is an example of a country that has experienced periods of low but sustained deflation. Typically, central banks target lower annual inflation rates to keep the economy active (usually around 2%).

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

Monetary policy

Central banks can lower interest rates to encourage borrowing and spending. Lower rates allow businesses and consumers to take out cheaper loans, which can stimulate economic activity. Another option is quantitative easing (QE), which increases the money supply and encourages spending.

Tax policy

Fiscal policy measures may involve increased government spending to stimulate demand in the economy. In addition, tax cuts may be implemented to increase the disposable income of consumers and businesses, encouraging them to spend and invest more.

Advantages of Deflation

Cheaper goods: During deflation, the value of money increases, making goods more affordable, thereby improving the standard of living.

Reduced Business Expenses: Businesses can benefit from reduced costs of materials needed for their production.

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

Disadvantages of Deflation

Less spending: Deflation can cause consumers to delay purchases, expecting prices to fall further. This reduces demand for goods and services, which can lead to slower economic growth.

More debt: The value of debt tends to increase during deflation, making it more difficult for borrowers to repay their loans.

Rising unemployment: Businesses may respond to reduced consumer spending by cutting costs, often through mass layoffs.

Conclusion

Deflation refers to a decline in the general level of prices. While it can make goods more affordable and encourage saving, it also leads to reduced consumer spending, increased debt, and higher unemployment.

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