Key aspects

• Deflation describes a fall in prices, which can increase the purchasing power of your money. It can lead to more affordable goods and services and allow for greater savings.

• Although often considered a good thing, persistent deflation can negatively impact 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 often perceived as a good thing, as it can give you more for your money. But in some cases, it can also have negative effects on the economy.

Episodes of problematic deflation are rare. In general, our financial system is more susceptible to inflation than deflation. Still, 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 possible effects of deflation.

Common causes of deflation

Lower aggregate demand

Aggregate demand represents the overall demand for all goods and services. When people and businesses spend less money, demand decreases, often resulting in lower prices.

Increase in supply

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

Strong currency

When a country's currency is strong, it can buy more foreign goods, which results in cheaper imports and lower prices for domestic goods. In addition, a strong currency can make a country's exports more expensive, 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 is related to an increase in prices. Deflation therefore increases the purchasing power of money, while inflation does the opposite.

Causes

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

In contrast, inflation can be caused by increased aggregate demand, higher production costs and expansionary monetary policy. In practice, it is usually a combination of factors.

Effects

During periods of deflation, gradually falling prices and strengthening local currencies encourage consumers to increase their savings and delay purchases. Lower demand can lead to economic stagnation and rising 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 combat deflation

Although inflation is often perceived as more worrying, both inflation and deflation can cause problems. Japan is an example of a country that has experienced some periods of low but long-lasting deflation. Central banks generally aim for lower annual inflation rates to keep the economy active (typically 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 make it cheaper for businesses and consumers to borrow, 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 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 and improving the standard of living.

Lower costs for businesses: Businesses can benefit from lower costs of the materials needed for their production.

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

Disadvantages of deflation

Less spending: Deflation can lead consumers to delay purchases, waiting for 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 harder for borrowers to repay their loans.

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

Conclusions

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

Further reading

• What is stagflation?

• What are economic models?

• What is the PCE deflator and how does it work?

• What is quantitative contraction (QT)?

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