In economics, deflation occurs when there is a general decline in prices for goods and services across all segments of the industry. As prices decline, the purchasing power of money rises over time.
Deflation benefits the end consumer as their purchasing power increases. They can buy more goods and services due to lower prices with the same income over time.
Purchasing power means the value of one unit of money that can buy the number of goods or services. During inflation, rising prices decrease the value of one unit of money that can buy the number of goods and services.
Purchasing power means your home currency’s buying power.
During deflation, purchasing power increases, which means the value of your home currency increases. Thus, you can buy more goods and services for the same amount of money.
Deflation is the opposite of inflation. To put it another way, deflation is negative inflation.
A borrower who is bound to pay his debt will not be happy as the money he paid is worth more than the money he borrowed. Deflation has a negative impact on the economy.
What triggers deflation?
Decrease in supply of money and credit without a corresponding decrease in economic production of goods and services causes deflation. When the supply of money comes down, the prices of all goods and services tend to fall.
A decline in prices can be caused due to a number of other factors such as decrease in demand of all goods and services, increase productivity with decrease in money supply.
A decrease in demand for goods and services subsequently forced the businesses to lower their prices.
When the output of the economy grows faster than the money supply, prices fall due to lower production costs and lack of demand for goods due to decrease in money supply.
Here is a list of causes that triggers deflation;
- Stagnant economic growth;
- Restriction of the central bank in money supply. When the central bank increases interest rates for an extended period of time, credit becomes expensive due to which money supply decreases leading to lesser demand of goods and services, ultimately falling in prices.
- More supply of goods and services but lesser demand;
- Due to unemployment and low wages end consumers have less money in hand. They spend less and save more for rainy days. Due to this problem demand decreases as a result prices fall. Negative sentiment in the economy may discourage people to spend more and increase their savings, which leads to decrease in demand for goods and services.
- Excessive production due to technology advancement reduces cost of production and increases supply of goods. With lesser demand and higher supply, prices of goods and services fall.
Above causes of deflation can be classified under two heads: (1) downfall in demand of goods and services with increase in supply, and (2) mismanagement in money supply by the central banks.
Is deflation bad or good?
Due to the decrease in prices of all goods and services, businesses will not be interested to invest more money. When owners of assets saw their asset prices fall, they postponed their investment with an expectation of further fall in prices, resulting in lower economic activity.
Deflation is considered bad for the economy even though it increases the purchasing power of money.
If deflation is not controlled then it may lead us to depression. It causes negative effects on the economy, increases unemployment, increase in the real value of debt, lower production, and lower wages.
Many economists think that deflation is more dangerous than inflation as economic activity falls with a fall in the aggregate demand, wages, employment and investments.
Example of deflation
In the 1930s the United states experienced significant deflation. The period between 1930 and 1933 is referred to as the Great Depression.
In the 21st century, deflation occurred between 2007 and 2008, this period is referred to by economists as the Great Recession.
In the 1990s Japan experienced deflation. Japan experienced a period of economic stagnation and price deflation from 1991 through 2001. This period is known as Japan’s “Lost Decade”.
Inflation vs. Deflation: Comparison
Here is a table showing the comparison of inflation with deflation in economics;
| Particulars | Inflation | Deflation |
| Definition | Inflation is an economic term which means there is a rate of increase in prices over a given period of time. | Deflation is the opposite of inflation. It means an economic slowdown, where prices of goods and services decline. |
| Cause | Lack of demand;Higher supply of goods and services with low demand;Contraction of money supply;Low investment | Increase in demandIncrease of money supplyLow interest ratesHigher investments |
| Effect | Decreases the purchasing power of money. Increases the cost of living. | Increases the purchasing power of money and decreases the cost of living. |
Companies with less debt and more cash reserves are generally considered as an attractive investment during deflation.
