Deflation

What Is Deflation?

Deflation refers to a situation where is a decrease in the prices for goods and services and a corresponding decline in purchasing power across the economy.

When it begins as a reduction in prices, it is considered a positive change, but when it is spread throughout the economy, it is a different situation altogether.

It is the direct opposite of inflation and does not bode well for a nation or its currency.

Deeper Definition

It is essentially a gradual decrease in prices across the board and signals imminent hard times for the economy or a full-blown recession.

By this means, the nominal costs of capital, labor, goods, and services fall regardless of their relative prices staying unchanged.

From the standpoint of demand and supply, it occurs whenever there is either:

An increase in demand for OR decrease in the supply of money

A decline in demand for OR increases the supply of goods.

It initiates a negative feedback loop whose pathway involves an overall reduction in prices of goods and services, hoarding of cash in hopes of even lower price rates, a sharp decrease in the amount of money in circulation, increased purchasing power of the currency, the inability of businesses to sell off their goods and services due to unprofitability, downsizing by the business owners to manage the situation and a consequent increase in the unemployment rate.

The entire cycle is referred to as a deflationary spiral. This hugely contributed to the Panic of 1837 and the Great Depression.

Another viewpoint from which deflation can be observed is in the value of debts. In a state of deflation, the real value of debts increases; that is, the money owed by a borrower is worth more, leaving the said borrower in further debt.

Deflation can be measured by common economic indicators like the Consumer Price Index(CPI). The prices of goods and services are calculated and published every month to compare against each other.

It differs from disinflation, by which the rates of inflation are reduced, and the prices are still higher by a reduced rate, e.g., $4 to $4.7 instead of $5.

Deflation Example

In 2007 and 2008, the Great Recession happened in the United States. Inflation rates dropped below 0%, hence deflation occurred.