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Deflation

Did you know deflation is actually more of an issue than its more famous sibling, inflation? All of the media and political hype goes to inflation being one of the biggest issues the economy faces, while in reality, the falling prices associated with deflation are much more worrisome. But falling prices are good right?! For the consumer's short-term pocketbook, yes, but for producers and the country as a whole...not so much. Stick around to find out more about deflation and its impact on the economy.

Deflation Definition Economics

Deflation definition in economics is a decrease in the general price level. Deflation does not only affect one industry in economics. By the nature of the economy it is highly unlikely that one industry is completely insulated from others. What is meant by this is that if one area of the economy experiences a drop in prices, most likely so will other related industries.

Deflation is a decrease in the general price level in the economy.

Deflation cartoon figure buying apples before deflation and buying more apples after deflation with five dollars StudySmarterFig. 1 - Deflation increases the purchasing power of money

When deflation occurs, the overall price level across the economy falls. This means that the purchasing power of an individual's money actually increased. As prices fall, the value of the currency increases. One unit of currency can purchase more goods.

Fred has $12. With those $12, he can buy three gallons of milk at $4 each. Over the next month, deflation causes the price of milk to drop to $2. Now, Fred can buy six gallons of milk for the same $12. His purchasing power increased and with $12 was able to purchase twice as much milk.

At first, people might like the thought of prices decreasing, until they realize that their wages are not exempt from the decrease. In the end, wages are the price of labor. In the example above, we saw that with deflation, purchasing power increases. However, this effect is short-lived, since the price of labor will eventually reflect the falling prices. This results in people wanting to hold on to their cash instead of spending it, which further slows the economy.

Economics students beware: Deflation and Disinflation are NOT interchangeable nor are they the same thing! Deflation is a decrease in the general price level while disinflation is when the rate of inflation slows down temporarily. But the good thing for you is you can learn all about disinflation from our explanation - Disinflation

Deflation vs Inflation

What is deflation vs inflation? Well, deflation has been around for as long as inflation has been around, but it does not occur as often. Inflation is an increase in the general price level, whereas deflation is a decrease in the general price level. If we think of inflation and deflation in terms of percentages, inflation would be a positive percentage while deflation would be a negative percentage.

Inflation is an increase in the general price level.

Inflation is a more familiar term since it is a more common occurrence than deflation. The general price level rises almost every year and a moderate amount of inflation is an indicator of a healthy economy. Moderate levels of inflation can indicate economic development and growth. If inflation is too high, then it can severely limit people's purchasing power and cause them to use up their savings to make ends meet. Eventually, this condition becomes unsustainable and the economy falls into a recession.

Perhaps the most obvious example of deflation is the time in U.S. history from 1929 to 1933 known as The Great Depression. This was a time when the stock market crashed and the real GDP per capita dropped by around 30% and unemployment reached 25%.1 In 1932, the U.S. saw a deflation rate of over 10%.1

Inflation is a bit easier to control than deflation. With inflation, the Central Bank can implement a contractionary monetary policy that reduces the amount of money in the economy. They can do this by increasing interest rates and bank reserve requirements. The Central Bank can do this for deflation as well, by implementing an expansionary monetary policy. However, where they can raise interest rates as much as necessary to curb inflation, the Central Bank can only lower the interest rate to zero when deflation is occurring.

Another difference between inflation and deflation is that inflation is an indicator that the economy is still growing. Deflation is a bigger problem since it indicates that the economy is no longer growing and there is a limit to how much the Central Bank can do.

Monetary policy is a valuable tool used to manipulate and stabilize the economy. To learn more, have a look at our explanation - Monetary Policy

Types of Deflation

There are two types of deflation. There is bad deflation, which is when aggregate demand for a good falls faster than aggregate supply.2 Then there is good deflation. Deflation is considered "good" when aggregate supply grows faster than aggregate demand.2

Bad Deflation

It is easy to associate a decrease in the general price level with a general benefit to society. Who does not want prices to fall so that they can catch a break? Well, it does not sound so nice when we have to include wages in the general price level. Wages are the price of labor so if prices fall, so do wages.

Bad deflation occurs when aggregate demand, or the total quantity of goods and services demanded in an economy, falls faster than aggregate supply.2 This means that people's demand for goods and services has fallen and businesses are bringing in less money so they must lower or "deflate" their prices. This is related to a reduction of the money supply which reduces income for businesses and employees who then have less to spend. Now we have a perpetual cycle of downward pressure on prices. Another issue with bad deflation is the resulting unsold inventory that firms produced before they realized that demand was falling and for which they now have to find a place to store or on which they have to accept a major loss. This effect of deflation is the more common one and has the greater impact on the economy.

Good Deflation

So now how can deflation still be good? Deflation can be beneficial in moderation and when it is the result of lower prices due to an increase in aggregate supply rather than a decrease in aggregate demand. If aggregate supply increases and there are more goods available without a change in demand, prices will fall.2 Aggregate supply might increase due to a technological advancement that makes production or materials cheaper or if production becomes more efficient so more can be manufactured.2 This makes the real cost of the goods cheaper resulting in deflation but it does not cause a shortage in the money supply since people are still spending the same amount of money. This level of deflation is typically small and balanced out by some of the Federal Reserve's (The Fed's) inflation policies.2

What are some causes and control of deflation? What causes it and how can it be kept in check? Well, there are several options. Let's start with the causes of deflation

Causes and Control of Deflation

Rarely does an economic issue ever have a single cause, and deflation is no different. There are five main causes of deflation:

  • Decrease in aggregate demand/ Low confidence
  • Increased aggregate supply
  • Technological advances
  • Decrease money flow
  • Monetary policy

When aggregate demand in an economy falls, it causes a decrease in consumption which leaves producers with surplus products. To sell these excess units, prices must decrease. Aggregate supply will increase if suppliers compete with each other to produce similar goods. They will then try to implement the lowest prices possible to remain competitive, contributing to lower prices. A technological advancement that expedites production will also contribute to an increase in aggregate supply.

Contractionary monetary policy (increasing interest rates) and a decrease in the money flow slow the economy as well because people are more hesitant to spend their money when prices are falling because it holds more value, they are unsure of the market, and they want to take advantage of higher interest rates while waiting for prices to fall even further before buying things.

Control of Deflation

We know what causes deflation, but how can it be controlled? Deflation is more difficult to control than inflation due to some of the limitations that monetary authorities run into. Some ways to control deflation are:

  • Changes to monetary policy
  • Decrease interest rates
  • Unconventional monetary policy
  • Fiscal policy

If monetary policy is a cause of deflation, then how can it help control it? Fortunately, there is not one strict monetary policy. It can be tweaked and adjusted to encourage the result that monetary authorities want. A limitation that the Central Bank runs into with monetary policy is that it can only lower the interest rate to zero. After that, negative interest rates are implemented, which is when borrowers start getting paid to borrow and savers start getting charged to save, which serves as yet another incentive to start spending more and hoarding less. This would be an unconventional monetary policy.

Fiscal policy is when the government changes its spending habits and tax rates to influence the economy. When there is a risk of deflation or it is already happening, the government can lower taxes to keep more money in the citizen's pockets. They can also increase their spending by issuing stimulus payments or offering incentive programs to encourage people and businesses to start spending again and move the economy forward.

Consequences of Deflation

There are both positive and negative consequences of deflation. Deflation can be positive in that it strengthens the currency and increases the consumer's purchasing power. Lower prices can also encourage people to increase their consumption, although excessive consumption can also have a negative impact on the economy. This will happen if price declines are small, slow, and short-lived because people will want to take advantage of lower prices knowing that they likely won't last long.

Some negative consequences of deflation are that as a response to the greater purchasing power of their money, people will choose to save their money as a method of storing wealth. This reduces the money flow in the economy, slowing it down and weakening it. This will happen if price declines are large, rapid, and long-lasting because people will wait to buy things in the belief that prices will continue to fall.

Another consequence of deflation is that the repayment burden on existing loans increases. When deflation occurs, wages and income decrease but the actual dollar value of the loan does not adjust. This leaves people tethered to a loan that is way out of their price range. Sound familiar?

The 2008 financial crisis is another example of deflation. In September of 2009, during the recession caused by the banking crash and housing bubble burst, the G-20 countries experienced a 0.3% deflation rate, or -0.3% inflation.3

This may not sound like much, but considering how rare of an occurrence it is and how dreadful the 2008 recession was, it is safe to say that monetary authorities would much rather deal with some low to moderate inflation than deflation.

Deflation - Key takeaways

  • Deflation is when there is a decrease in the general price level whereas inflation is an increase in the general price level. When deflation occurs, an individual's purchasing power increases.
  • Deflation can be a result of an increase in aggregate supply, a decrease in aggregate demand, or a decrease in the money flow.
  • Deflation can be controlled through fiscal policy, adjusting the monetary policy, and implementing an unconventional monetary policy like negative interest rates.
  • The two types of deflation are bad deflation and good deflation.

References

  1. John C. Williams, The Risk of Deflation, Federal Reserve Bank of San Francisco, March 2009, https://www.frbsf.org/economic-research/publications/economic-letter/2009/march/risk-deflation/#:~:text=The%20Great%20Depression,-The%20natural%20starting&text=Between%201929%20and%201933%2C%20real,deflation%20exceeding%2010%25%20in%201932.
  2. Michael D. Bordo, John Landon Lane, & Angela Redish, Good versus Bad Deflation: Lessons from the Gold Standard Era, Nation Bureau of Economic Research, February 2004, https://www.nber.org/system/files/working_papers/w10329/w10329.pdf
  3. Mick Silver and Kim Zieschang, Inflation Drops to Negative Territory, International Monetary Fund, December 2009, https://www.imf.org/external/pubs/ft/fandd/2009/12/dataspot.htm

Frequently Asked Questions about Deflation

Deflation definition in economics is when the general price level experiences a decrease.

The Great Depression of 1929-1933 is an example of deflation.

No, deflation is the bigger problem since it indicates that the economy is no longer growing since prices are falling. 

A decrease in aggregate demand, a decrease in money flow, an increase in aggregate supply, monetary policy, and technological advances can all cause deflation.

Deflation affects the economy by decreasing prices and wages, slowing down the flow of money, and limiting economic growth. 

Final Deflation Quiz

Question

Define deflation.

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Answer

Deflation is a decrease in the general price level.

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Question

When deflation occurs, what happens to a currency's value?

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Answer

The value of the currency rises.

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Question

True/False: Deflation is worse than inflation because it indicates that the economy is moving too quickly.

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Answer

False. While deflation is worse than inflation, it is worse because it indicates a lack of economic growth.

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Question

When people are worried about deflation would they be more inclined to spend their money or save it?

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Answer

They would be inclined to save it since it would be more valuable. 

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Question

What happens to the amount of cash flowing through the economy when an economy is experiencing deflation?

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Answer

The amount of cash flowing through decreases since people are more inclined to hoard it.

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Is deflation or inflation more common?

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Answer

Inflation.

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Question

What do low to moderate levels of inflation tell us about the health of the economy?

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Answer

It can tell us that it is experiencing development and growth. 

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Question

Was there any deflation during The Great Depression?

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Answer

Yes, in 1932 the U.S. experienced over 10% deflation. 

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What are the two types of deflation?

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Answer

There is good deflation and bad deflation.

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Question

What impact does deflation have on the economy?

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Answer

Deflation impacts the economy by decreasing prices and wages, slowing down the flow of money, and limiting economic growth.

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Question

List three causes of deflation.

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Answer

  1. A decrease in aggregate demand
  2. A decrease in money flow
  3. An increase in aggregate supply
  4. Monetary policy
  5. Technological advances

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Question

Why does deflation increase the repayment burden on loans?

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Answer

Because wages may decrease but the actual dollar value of the loan does not adjust to the new value of the currency making the real value of the loan higher.

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How can fiscal policy help the issue of deflation?

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Answer

Fiscal policy is when the government adjusts its spending and tax rates. If deflation is an issue then the government can decrease taxes and increase its spending.

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Question

When is deflation good?

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Answer

Deflation can be good when aggregate supply increases and demand stays the same because it causes the price level to decrease. In this case there is no lack of money that caused the decrease which would be problematic.

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When is deflation bad?

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Answer

It is bad when aggregate demand falls but aggregate supply stays the same. This causes the price level to fall because there is a shortage of money flowing into a business which results in a decrease in the income of both the firm and its employees. 

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