What is Deflation?

Deflation is a decrease in the general price level of goods and services. It is the opposite of inflation, which is an increase in the general price level of goods and services. When deflation occurs, aggressive action is typically taken by central banks and governments to encourage spending and investment by lowering interest rates, increasing liquidity and providing government spending depending on the severity of the deflationary trend.

Deflation is typically an indication of a contracting economy and is one of the central talking points of economists when discussing potential recessions. When deflation occurs, it can be caused by a decrease in aggregate demand, a decrease in the cost of production in an industry, or an increase in credit availability due to lower interest rates.

The Effects of Deflation

Deflation can be harmful for an economy by shrinking aggregate demand. This is because a decrease in the general price level translates to a decrease in the quantity of goods and services, which ultimately affects production, wages and hiring levels. If prices are dropping, consumers will usually wait to purchase certain goods and services, as they can buy more of the same good for less money at a future date. This decreases demand, putting downward pressure on prices which can escalate into a deflationary spiral.

Deflation can also lead to debt deflation, which is when the decrease in prices is accompanied by an increase in debt. As the value of money increases, consumers and businesses have extra incentives to save money—which can decrease spending, thereby reducing demand. While some economists advocate debt deflation as a solution to runaway inflation, most economists believe it to be a dangerous and inefficient economic phenomenon that can actually stunt economic growth.

Fighting Deflation

In order to fight deflation, central banks and governments typically take aggressive steps to stimulate the economy. This could include aggressively cutting interest rates to make borrowing easier, increasing the money supply, and providing government spending. Another less conventional step is to target a particular sector of the economy. For example, the government may decide to focus on stimulating the housing market by providing incentives for buyers and sellers.

Conclusion

Deflation is a decrease in the general price level of goods and services and is typically an indication of a contracting economy. It can cause an economy to suffer by shrinking aggregate demand and by leading to debt deflation. To fight deflation, central banks and governments typically take aggressive steps such as cutting interest rates and increasing liquidity. Although deflation can be harmful, it can also provide certain opportunities to consumers and businesses that take advantage of a lower cost of production or lower interest rates.