Key points

  • Deflation is a fall in prices that increases the purchasing power of money, making goods and services more affordable and allowing consumers to save more.

  • Temporary deflation is often considered a positive development, but prolonged deflation can have negative effects on the economy. If left unchecked, deflation can increase unemployment and slow economic growth.

What is deflation

Deflation is a decrease in the prices of goods and services in an economy. Deflation is generally considered beneficial because consumers can spend less and buy more. But in some cases, it can have negative consequences.

Problematic deflation is rare. Generally, the financial system is more susceptible to inflation than to deflation. However, it is useful to understand its negative effects in case you encounter prolonged deflation in your country.

Let's look at the common causes and potential consequences of deflation.

Common Causes of Deflation

Low aggregate demand

Aggregate demand is the total demand for all goods and services in an economic system. When consumers and businesses spend less money, demand decreases, which often leads to lower prices.

Increase in supply

If companies produce more than people want to buy, prices can fall because of excess supply. For example, this can arise from a new technology that makes production cheaper and more efficient.

Strong currency

When a country has a strong currency, it can buy more foreign goods. This leads to cheap imports and lower prices for domestic goods. In addition, a strong currency can make exports more expensive for other countries, which then reduces demand for the goods and services exported.

Comparison of deflation and inflation

Deflation and inflation are both changes in the overall cost of goods, but they have different causes and consequences for the economy.

Definition

Deflation is a decrease in the prices of goods and services, and inflation is an increase in prices. Thus, deflation increases the purchasing power of money, and inflation decreases it.

Reasons

Deflation can be caused by a decrease in aggregate demand, an increase in supply, or new technologies.

Inflation can occur due to increased aggregate demand, higher production costs, and stimulative monetary policy. Inflation usually occurs due to a combination of factors.

Effects

During periods of deflation, gradual price falls and a stronger local currency encourage consumers to increase their savings and postpone purchases. Reduced demand can eventually lead to economic stagnation and increased unemployment.

Inflation reduces the value of money and creates uncertainty, which encourages people to spend more before prices rise even more.

How to fight deflation

Inflation is more worrisome, but both economic conditions can cause problems. Japan, for example, has experienced several periods of low but prolonged deflation. In general, central banks aim for lower annual inflation rates to keep the economy moving (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 borrowing less expensive for businesses and consumers, which boosts economic activity. Banks can also use quantitative easing, which increases the money supply and encourages spending.

Fiscal policy

Through fiscal policy, the government can increase public spending to stimulate demand in the economy. It can also cut taxes so that consumers and businesses have more spare cash to spend and invest.

The Pros of Deflation

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

Reduced business costs: Materials are cheaper, so companies spend less on production.

More savings: As the value of money increases, people may be more inclined to save rather than spend.

Disadvantages of deflation

Less spending: Consumers may delay purchases in anticipation of further price falls. This reduces demand for goods and services, which can lead to slower economic growth.

More debt: During deflation, the cost of debt increases, making it harder for borrowers to repay their loans.

Rising unemployment: With consumer demand falling, businesses may cut costs, often through mass layoffs.

In conclusion

Deflation is a decline in the general price level. Deflation makes goods more affordable and consumers more likely to save. However, deflation can also lead to reduced consumer spending, increased debt, and higher unemployment.

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