What is Deflation?

What is Deflation in Economics?

We all buy goods and services, but the prices of these goods are bound to change over time. Prices generally rise gradually over time, but they can also decline during periods of deflation. When prices are low, your purchasing power increases, which means you will be able to buy more goods and services with the same amount of money. Deflation can be a good thing for your wallet, but it can also be bad for the economy at large. Learn more about deflation, what causes it, and how it can affect your finances.

What Is Deflation in Economics?

Deflation is an economic term. It’s defined as the fall of prices in an economy. As a result, the consumers in this economy have more purchasing power. Deflation may refer to a particular subset of the economy, such as oil price or the economy of an entire country. It is the opposite of inflation, which is when prices rise.

What Causes Deflation?

Prices are typically set by supply and demand. When supply is high, and demand is low, prices tend to go down. Deflation occurs when the economy produces more goods and services than the market demands, usually due to a sudden boost in productivity. Consider the case of automation. New technology can quickly increase the number of products companies can produce while limiting the cost of doing business. Companies may eventually pass those savings down to consumers in the form of lower prices.

Deflation can also occur when demand for a particular product or market subsides. Companies and consumers may no longer need a product or service or choose to conduct their business in another country. There might not be enough consumers in the market to consume all the available goods and services. 

Monetary policy can also lead to deflation. The Federal Reserve regularly adjusts interest rates in the United States. High-interest rates make it harder for companies and consumers to borrow money, leading to a decline in demand, especially in a debt-laden economy where economic growth depends on the flow of capital. The Fed also controls the supply of money. Printing more money will lead to inflation, while limiting the currency in circulation will lead to deflation.

Every action has a reaction. Deflation may also be a reaction to temporary inflation. Prices will settle as economic activity begins to slow.

What Is Currency Deflation?

When economists talk about deflation, they often mean currency deflation. Currency deflation is when the value of a currency goes up. Currencies will rise and fall in value over time. Your money will be worth more than it was before, which allows you to consume more goods and services without spending more money. When exchanging currency, your money can be used to purchase more currency in another country.

Currency deflation results from various economic factors, including employment rates, monetary policy, and aggregate demand for the country’s products and services.

How Is Deflation Measured?

In the U.S., deflation and inflation are measured by the Consumer Price Index. The organization tracks the prices of commonly used goods and services, including necessities like food, transportation, housing, and energy. Economists will then use this information to track how much prices change over time. When the CPI reports that prices are lower than they were the year before, the country has entered a period of deflation.

Is Deflation Bad for the Economy?

There’s a lot of debate among economists regarding how deflation affects the economy. In many ways, falling prices can be a good thing for consumers. You will likely have more money left over now that most items cost less than they did before. This outcome can help many consumers save for the future or pay off their debt, leading to economic growth down the line.

Some economists believe that consumers may hold off on purchasing goods and services if they think prices will continue to decline, but this doesn’t always hold true. Deflation often refers to the prices of essential goods and services, like food and housing, that can’t be consumed later. When deflation occurs, consumers will still need these items, which means demand shouldn’t be affected. 

Deflation can also be good for the economy if it represents a boon in productivity, including new technological advancements that allow companies to produce more goods using the same amount of, if not fewer, resources. As production costs go down, so do the prices of goods and services. This decrease can also lead to better-quality products and services as companies focus more on research and development and less on manufacturing.

On the other hand, deflation can also be bad for the economy. It may represent a lack of consumers in a given market and is often associated with higher unemployment. Money may be more valuable, but fewer people may have less of it.

Deflation can be bad news for investors in today’s highly complex financial world. Monetary policy and significant financial decisions are typically made using speculation. Large companies often rely on the flow of credit to finance their operations rather than actual money saved. They look at current prices when setting their expectations for future growth. If prices continue to fall, companies could go out of business, and borrowers may default on their loans, triggering a recession. Many investors may pull out, liquidate their assets, or demand their money back, which would drive down prices further and only worsen the recession, as was the case during the Great Depression.

Many economists agree that some degree of inflation can be good for economic growth. It shows that demand for products and services is commensurate with supply. If prices rise or fall too fast, it can negatively affect the economy.

The Bottom Line

When considering your finances, deflation can help you save money in the short term as your purchasing power increases. Still, it can also mean that the economy is headed for a temporary recession. Government officials and lenders will often course correct when deflation occurs to prevent prices from falling further. Many investors avoid selling off investments during deflation, as the economy will likely rebound as monetary policy changes.