Key Takeaways
Deflation describes a drop in prices, which can increase the purchasing power of your money. It may result in more affordable goods and services and allow for more savings.
While it’s often considered a good thing, persistent deflation can negatively affect the economy. If not managed well, deflation can increase unemployment and slow down economic growth.
What Is Deflation?
Deflation describes a decrease in the price of goods and services in an economy. In practice, deflation is usually perceived as a good thing as it can give you more bang for your buck. 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 eventually face persistent deflation in the country you live in, it’s helpful to know some of its negative effects.
Let’s take a closer look at 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, the demand goes down, often resulting in lower prices.
Increase in supply
If businesses produce more than people want to buy, the excess supply can also lead to lower prices. For example, this may 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, leading to cheaper imports and lower prices for domestic goods. In addition, a strong currency can make a country's exports more expensive for other nations, reducing demand for exported goods and services.
Deflation vs. Inflation
While both deflation and inflation 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 general price of goods and services, inflation relates to a price increase instead. So, deflation increases the purchasing power of money, while inflation does the opposite.
Causes
As we’ve learned, deflation can be caused by a decrease in aggregate demand, an increase in supply, or new technologies.
In contrast, inflation may occur due to an increase in aggregate demand, higher production costs, and expansionary monetary policy. In practice, it’s usually a combination of factors.
Effects
During periods of deflation, the gradual drop in prices and strengthening of the local currency encourages consumers to grow their savings and delay purchases. The lower demand may eventually 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
While inflation is usually perceived as more concerning, 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. In general, central banks aim for lower rates of annual inflation to keep the economy active (usually around 2%).
To tackle 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 take out loans, which can stimulate economic activity. Another option is to perform 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 can be implemented to increase disposable income for consumers and businesses, encouraging them to spend and invest more.
Pros of Deflation
Cheaper goods: During deflation, the value of money increases, making goods more affordable and improving the standard of living.
Lower business expenses: Businesses 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.
Cons of Deflation
Less spending: Deflation can lead consumers to delay their purchases, expecting prices to fall further. This decreases the demand for goods and services, potentially resulting in 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.
Closing Thoughts
Deflation refers to a decrease in the general price level. While it can make goods more affordable and encourage savings, it also results in reduced consumer spending, more debt, and rising unemployment.
Further Reading
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