Key Points
Deflation describes a decrease in prices that can increase the purchasing power of your money. Deflation can make goods and services more affordable and allow for more savings.
Although often considered a good thing, persistent deflation can have negative effects on the economy. If not managed properly, deflation can increase unemployment and slow economic growth.
What is Deflation?
Deflation describes a decrease in the prices of goods and services in an economy. In practice, deflation is usually considered a good thing because it increases the purchasing power of your money. However, in some cases, deflation can also have negative effects on the economy.
Problematic cases of deflation are rare. Overall, our financial system is more vulnerable to inflation than deflation. However, if you end up facing persistent deflation in your country, it would be helpful to know some of its negative effects.
Let's take a closer look at the common causes and potential effects of deflation.
Common Causes of Deflation
Lower aggregate demand
Aggregate demand represents the broad demand for goods and services. When people and businesses spend less money, demand falls and often results in lower prices.
Increased supply
If businesses produce more than people want to buy, excess supply can also lead to lower prices. For example, this might occur because of new technology that makes production cheaper and more efficient.
Strong currency
A strong currency can buy more of a country's goods, 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
While deflation and inflation both relate to general price changes, each has different causes, effects, and implications for the economy.
Definition
Deflation refers to a general decrease in the prices of goods and services, while inflation is related to an increase in prices. So, deflation increases the purchasing power of money, while inflation does the opposite.
Reason
As we have learned, deflation can be caused by a decrease in aggregate demand, an increase in supply, or new technology.
In contrast, inflation can occur due to increased aggregate demand, higher production costs, and expansionary monetary policy. In practice, the cause is usually a combination of factors.
Effect
During deflationary periods, gradual price declines and a strengthening local currency encourage consumers to increase their savings 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 money before prices rise further.
How to Overcome Deflation
While inflation is usually considered more of a concern, both inflation and deflation can cause problems. Japan is an example of a country that has experienced several periods of low but prolonged deflation. In general, central banks aim to keep annual inflation rates low enough to keep the economy moving (usually around 2%).
To overcome deflation, the government and the central bank use fiscal and monetary policies.
Monetary policy
Central banks can lower interest rates to encourage borrowing and spending. Lower interest rates make borrowing cheaper for businesses and consumers, which can stimulate economic activity. Another option is quantitative easing (QE), which increases the money supply and encourages spending.
Fiscal policy
Fiscal policy measures may involve increasing government spending to boost demand in the economy. In addition, tax cuts may be implemented to increase disposable income for consumers and businesses, encouraging them to spend and invest more.
Pro Deflation
Cheaper goods: During deflation, the value of money increases, making goods more affordable and raising the standard of living.
Lower business costs: Businesses can benefit from reduced costs of materials needed for their production.
Increased savings: When the value of money increases, people may be more likely to save rather than spend.
Counter Deflation
Spending Declines: Deflation can cause consumers to delay purchases in the hope that prices will fall further. This reduces demand for goods and services, potentially leading to slower economic growth.
Debt increases: Debt values ââtend to increase during deflation, making it more difficult for borrowers to repay their loans.
Unemployment rises: Businesses may respond to falling consumer spending by cutting costs, often through mass layoffs.
Cover
Deflation is a decline in the general price level. While it can make goods more affordable and encourage saving, it also leads to lower consumer spending, higher debt, and higher unemployment.
Further Reading
Disclaimer: This content is provided to you on an âas isâ basis for general information and educational purposes only without any representation or warranty of any kind. It should not be construed as financial, legal, or other professional advice or intended to recommend the purchase of any particular product or service. You should seek advice from an appropriate professional advisor. Where the article is contributed by a third party contributor, please note that the views expressed are those of the third party contributor and do not necessarily reflect the views of Binance Academy. Please read our full disclaimer here for more details. Digital asset prices can be volatile. The value of your investment may go down as well as up. You may not get back the amount you invested. You are solely responsible for your investment decisions. Binance Academy is not responsible for any losses you may incur. This material should not be construed as financial, legal, or other professional advice. For more information, please read our Terms of Use and Risk Warning.
