Deflation Definition - How Does It Affects the Economy

What is Deflation? – Definition

Deflation is a period of falling prices of goods and services in the economy. This is the opposite of inflation, which is when general prices rise over time.

Normally, economies are inflationary over the long term. This means that the value of money declines over time. A dollar is able to buy more today than if it were saved and used in the future. We are all familiar with good old days when the nominal prices of products were cheaper than today. However, as wages are loosely tied to the consumer price index, even though the cost of goods rise in nominal terms, consumers also earn more nominal dollars.

The Economic Effects of Deflation

Falling prices appear to be a desirable situation for consumers at first blush. However, deflation can quickly spiral out of control (called deflationary spiral) to the detriment of the wider economy and this has significant impact on the financial well being of every citizen.

When prices start to fall, consumers will start delaying purchases. We see this to some extent in the technology sector where prices of the same product tends to be lower over time. The difference is that in technology, new advances and falling component prices allow the producers to quickly replace the old models with new ones and they are able to keep generating new demand. When economic deflation is widespread, consumers have no incentive to purchase most products today (excepting the essentials).

Falling demand causes the producers to scale back production, stop capital expenditures, and reduce employment. This results in further erosion of consumer purchasing power and greater incentive for the consumers to hold back from spending their cash, causing a deflation spiral.

Deflation and Debt

Since debt levels stay constant in nominal terms, and deflation depreciates the value of the currency, the real value of the debt increases over time.

On an individual’s level, a person is faced with repaying debt with vastly depreciated current money. This is also compounded with the declined wages and rising unemployment, and it is easy to see how the situation can become untenable.

Businesses face similar situation. Businesses that were highly leveraged during normal times can suddenly find themselves unable to afford the debt payments in the face of declining revenues and profitability. Deflationary environments are generally replete with instances of business bankruptcies.

How Deflation Ends?

If left unchecked, deflation will end naturally over time. Business failures will eventually lead to supply reduction to a level below the present demand in the economy, in which case the prices will start to rise. However, this can take many years or decades and with sometimes unacceptable financial cost to the citizenry and the governments.

(See The Great Depression)

Most governments will choose not to wait and will act with a variety of stimulus aimed to increase the economic activity. This can range in the form of interest rate cuts (to make credit cheaper), increasing money supply (greater amount of money flowing in the system reduces the value of the money and therefore causes inflation), new job programs to aid employment and consumer purchasing power, etc. The risk with stimulus measures is that while it may be able to stem the deflation early, it leaves the economy vulnerable to runaway inflation at a later date if this is not carefully managed.

While deflation can be devastating, luckily it is not a very common economic occurrence.