Key Points

  • Deflation is described as a fall in prices to increase the purchasing power of money. Deflation can make goods and services more affordable and allow for greater savings.

  • Although often viewed as a positive phenomenon, 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 described as a decline in the prices of goods and services in an economy. In fact, deflation is often seen as a positive phenomenon because it can bring many significant benefits. However, in some cases, deflation can also have negative effects on the economy.

Periods of deflation are rare. In general, our financial system is more susceptible to inflation than deflation. However, if you are faced with persistent deflation in your country, it is helpful to understand some of the negative effects.

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

Common causes of deflation

Aggregate demand decreases

Aggregate demand represents the broad demand for goods and services. When people and businesses spend less money, demand falls, which usually leads to lower prices.

Supply increases

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

Strong currency

When a country's currency is strong, it can buy more foreign goods, making imports cheaper and lowering the prices of domestic goods. Additionally, a strong currency can make a country's exports more expensive relative to those of other countries, reducing demand for exported goods and services.

The difference between deflation and inflation

Although both deflation and inflation involve changes in general prices, they have different causes, effects, and impacts on the economy.

Define

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

Reason

As we know, deflation can be caused by a decrease in aggregate demand, an increase in supply, or new technology.

Conversely, inflation can occur due to increased aggregate demand, higher production costs, and expansionary monetary policy. In practice, this condition is often a combination of factors.

Effect

During deflation, prices fall and the domestic currency strengthens, encouraging consumers to save more money and delay purchases. Ultimately, reduced demand can lead to economic stagnation and increased unemployment.

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

How to fight deflation?

Although inflation is often considered the more worrisome, 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 the annual inflation rate low to keep the economy running (usually around 2%).

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

Monetary policy

Central banks can lower interest rates to encourage borrowing and spending. Lower interest rates make it cheaper for businesses and consumers to borrow money, 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 boost demand in the economy. Alternatively, implementing tax cuts may aim to increase disposable income for consumers and businesses, encouraging more spending and investment.

Advantages of deflation

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

Lower business costs: Businesses can benefit from reduced costs of raw materials required for production.

Save more: As the value of money increases, people may tend to save more than they spend.

Disadvantages of deflation

Spend less: Deflation can cause consumers to delay purchases, expecting prices to fall further. This reduces demand for goods and services, potentially slowing economic growth.

More debt: The value of debt tends to increase during deflation, making it harder for borrowers to repay.

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

Summary

Deflation refers to a general fall in prices. While deflation can make goods more affordable and encourage saving, it also leads to reduced consumer spending, increased debt, and increased unemployment.

Read more:

Disclaimer: This content is presented to you on an "as is" basis for general information and guidance purposes only, and does not constitute a representation or warranty of any kind. It should not be construed as financial, legal, or other professional advice. It is also not a recommendation to purchase any specific product or service. You should seek advice from appropriate professional advisors. In the case of articles contributed by third-party contributors, 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 fluctuate. The value of your investment may go up or down, and you may not get back the amount you invested. You are solely responsible for your investment decisions and Binance Academy is not liable for any losses you may incur. This material should not be construed as financial, legal, or other professional advice. For further information, please see our Terms of Use and Risk Disclosure.