Key points:

  • Deflation describes a fall in prices that can increase the purchasing power of your money. This can lead to more affordable goods and services and encourages savings.

  • Although deflation is generally considered a positive phenomenon, persistent deflation can have a negative effect 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 generally seen as a positive phenomenon, as it can give you more bang for your buck. But in some cases it can have a negative impact on the economy. 

Cases of problematic deflation are rare. In general, our financial system is more susceptible to inflation than deflation. However, if you end up facing persistent deflation in the country you live in, it's helpful to be aware of some of its negative effects.

Let's take a closer look at the common causes and potential consequences 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, which often leads to lower prices.

Increase in supply

If businesses produce more than people want to buy, excess supply can also cause prices to fall. For example, this can happen due to 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 leads to cheaper imports and lower prices for domestic goods. In addition, a strong currency can make a country's exports more expensive to other countries, reducing demand for exported goods and services.

Deflation and inflation

While both deflation and inflation are related to changes in the overall price of things, they have different causes and effects on the economy.

Definition

Deflation means a decrease in general prices for goods and services, inflation means, on the contrary, an increase in prices. So, deflation increases the purchasing power of money, and inflation does the opposite.

Reasons

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

Conversely, inflation can arise from increased aggregate demand, higher production costs, and expansionary monetary policy. In practice, this is usually a combination of factors.

Consequences

During periods of deflation, the gradual fall in prices and the strengthening of the local currency encourage consumers to increase their savings and delay 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 before prices rise further.

How to fight deflation

Although inflation is usually seen as a more worrisome phenomenon, both inflation and deflation can cause problems. Japan is an example of a country that experienced several periods of low but sustained deflation. In general, central banks aim for lower levels of annual inflation 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 stimulate borrowing and spending. Lower rates make credit cheaper for businesses and consumers, which can stimulate economic activity. Another option is quantitative easing (QE), which increases the money supply and stimulates spending.

Fiscal policy

fiscal policy measures may include increased government spending to stimulate demand in the economy. In addition, tax cuts can be introduced 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 rises, making goods more affordable and improving the standard of living.

Lower business costs: 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 than spend.

Disadvantages of deflation

Less spending: Deflation can cause consumers to delay their purchases in anticipation of further price falls. This reduces demand for goods and services, potentially slowing economic growth.

More debt: The cost of debt tends to rise during deflation, making it harder for borrowers to repay loans.

Rising unemployment: Companies may respond to reduced consumer spending by cutting spending, often with massive layoffs. 

Results

Deflation means a decrease in the general level of prices. While this may make goods more affordable and encourage savings, it also leads to reduced consumer spending, increased debt and rising unemployment.

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