Key points
Deflation describes a fall 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.
While it is often considered a good thing, persistent deflation can negatively affect 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, it is usually seen as a positive thing, as it can increase the purchasing power of your 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 susceptible to inflation than deflation. Still, if you ever find yourself facing persistent deflation in your country, it can be helpful to know some of its negative effects.
Letâs 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, usually resulting in lower prices.
Increased supply
If companies produce more than people want to buy, the excess supply can also lead to lower prices. For example, this could happen because of a new technology that makes production cheaper and more efficient.
Strong currency
When a country's currency is strong, it can buy more foreign goods, leading to cheaper imports and lower prices for domestic goods. Additionally, a strong currency can make a country's exports more expensive to other nations, reducing the demand for exported goods and services.
Deflation vs. Inflation
Although deflation and inflation both relate 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 overall price of goods and services, inflation refers to an increase in price. Therefore, deflation increases the purchasing power of money, while inflation does the opposite.
Causes
As we have seen, deflation can be caused by a decrease in aggregate demand, an increase in supply, or new technologies.
On the other hand, inflation can occur due to increased aggregate demand, higher production costs, and expansionary monetary policy. In practice, it is usually a combination of factors.
Effects
During periods of deflation, the gradual fall in prices and the strengthening of the local currency encourage consumers to increase their savings and postpone purchases. Consequently, lower demand can lead to economic stagnation and rising unemployment rates.
On the other hand, inflation reduces the purchasing power of money and creates uncertainty, encouraging people to spend more before prices rise further.
How to combat deflation
Although inflation is generally seen as the more serious concern, both inflation and deflation can cause problems. Japan is an example of a country that has experienced some periods of low but lasting deflation. Central banks generally aim for low 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 make it cheaper for businesses and consumers to borrow, which can stimulate economic activity. Another option is to engage in quantitative easing (QE), which increases the money supply and encourages spending.
Fiscal policy
Fiscal policy measures may involve increasing government spending to increase 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.
Advantages of deflation
Cheaper goods: During deflation the value of money increases, making goods more affordable and improving the standard of living.
Lower business expenses: Companies can benefit from lower 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 lead consumers to delay purchases, hoping that prices will fall further. This reduces demand for goods and services, possibly resulting in slower economic growth.
More debt: The amount 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.
Final considerations
Deflation refers to a decrease in the general level of prices. While it can make goods more affordable and encourage people to save money, it also results in reduced consumer spending, more debt, and higher unemployment.
Further reading
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