What is Deflation?

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Definition:

Deflation is the decrease in the price of goods and services over time, which results in an increase in the purchasing power of a currency.

🤔 Understanding deflation

Deflation is when the inflation rate is negative. It occurs when consumer prices decline across the board. A reduction in prices and the deflation that follows is usually a result of a decrease in consumer spending and a decrease in demand for products and services. Deflation causes an increase in the purchasing power of money. While many consumers might see this as a good thing, deflation can be indicative of a recession or economic instability. A recession usually means lower wages, fewer jobs, and a decline in the stock market. The Consumer Price Index (CPI) is responsible for measuring inflation and deflation rates.

Example

The most significant real-world example of deflation in recent history occurred during the Great Recession that began in 2007. By 2009, the rate of inflation had dipped below zero, meaning the country was experiencing deflation. This deflation accompanied an unemployment rate of over 10 percent, which was the highest the country had seen in more than 20 years.

Takeaway

Deflation is like a bad cough...

A cough is a symptom of a disease, but it’s not the disease itself. Likewise, deflation is a sign of a more significant problem in the economy. Deflation is a symptom of a disease, but it’s not the disease itself.

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How do we measure deflation?

The Bureau of Labor Statistics (BLS) measures inflation and deflation (aka negative inflation) using the Consumer Price Index (CPI), which is an index that measures the prices for roughly 80,000 goods and services. The CPI tracks whether prices are rising (which indicates inflation) or falling (which means deflation) over time.

It’s worth noting that there are two important economic indicators that the BLS does not include in the CPI: the stock market and housing prices. Rather than using housing prices, the CPI measures the cost of the monthly equivalent of owning a home. For this, it uses the cost of rent. This method can be misleading since home prices and rent prices do not always follow the same trajectory.

The federal government tracks the rate of inflation to ensure that the economy is growing at a healthy level. If inflation is rising too quickly, or if we’re experiencing deflation, then the government usually steps in with fiscal or monetary policies to correct the situation.

What causes deflation?

Several different factors can cause deflation, but at its core, deflation occurs when the price of consumer goods and services declines — And prices decline when the demand for products and services drops in relation to the supply.

This reduced demand might be a result of a decrease in the availability of money. The Federal Reserve, the central bank of the United States, can increase or decrease the supply of money and make money harder to get by raising interest rates on loans. When it’s harder to get money, people buy less.

Deflation can also be a result of increased productivity. When goods become easier and cheaper to make, companies can sell them at a lower price.

Finally, a decrease in demand could be the result of a reduction in government spending. For example, let’s say the government cuts spending on infrastructure. Suddenly some families in industries affected by this, like construction, have less money to spend. Demand goes down, and so prices typically go down as well.

What is the impact of deflation?

Deflation (or negative inflation) can be detrimental to a country’s economy. Deflation leads to a decrease in revenue, and therefore profit, for businesses. People aren’t spending as much money, either because they don’t have as much money or because the prices are lower.

When businesses see their profits dropping, they may have to cut costs to stay afloat. In many cases, they do this by laying off workers and cutting worker wages. Those unemployed or underpaid workers have to cut back on their spending.

Deflation can also harm people’s savings and retirement accounts. Deflation often accompanies a drop in the stock market. And when stock prices go down, it’s not uncommon for people to panic and sell their stocks. And if people are doing this after prices have already plummeted, they might see a considerable reduction in their net worth.

Deflation could also make it harder to get a loan. During a recession, lenders understand that people are struggling and may have a hard time making loan payments. Therefore, lenders might increase their standards of eligibility.

What is the difference between inflation and deflation?

While deflation is the decrease in prices and an increase in the purchasing power of money, inflation is the opposite: an increase in prices and a decrease in the purchasing power of money.

Inflation probably sounds worse to consumers because it means things are getting more expensive. But ultimately, modest inflation is better for the economy. The central bank likes to see a little bit of inflation every year, as it indicates that the economy is growing at a healthy level.

It’s not as if there are no downsides to inflation. Indeed, there are times when inflation reaches an unhealthy level, and prices are rising too rapidly. In these cases, the Federal Reserve might try to slow inflation a bit by reducing the money supply (though hopefully not enough to cause deflation) and raising interest rates.

Inflation is also bad news for long-term savings. Ultimately, the money you put into your retirement account — in dollar terms — is going to be worth quite a bit less 30 years from now that it is today. That’s why with 401(k) plans and individual retirement accounts, people typically invest them in securities instead of low-interest savings — it increases the likelihood their money will keep up with or surpass inflation.

Why is deflation bad for the economy?

At first glance, deflation might seem like a good thing. After all, what consumer doesn’t like when prices go down? Unfortunately, the process rarely ends with prices going down. Deflation is ultimately a downward spiral that builds on itself.

Let’s say demand drops because people have less money in their pockets. Because demand has gone down, companies must lower prices. When companies lower their prices, their profits go down. When company profits go down, they can’t pay their employees as much. And when employees aren’t making as much money, they have less money in their pockets to spend. It can create a vicious cycle.

Are there any positive effects of deflation?

The only positive effects of deflation are the short term ones. Deflation increases the purchasing power of money, meaning consumers can get more goods and services for their money. In the short term, consumers might be able to pay off debt or save more of their money. Eventually, though, unless deflation is corrected, the positive effects will be followed by the downward spiral of deflation and economic contraction.

How does the government solve deflation?

The Consumer Price Index (CPI) helps Congress and the Federal Reserve keep an eye on economic growth and make sure things are growing at a healthy rate. When that is not the case, meaning when the economy is growing too slowly or too quickly, the government can use fiscal policy and monetary policy to bring inflation to an appropriate level.

Fiscal policy is how Congress and the president keep the economy in check. They do this in two ways: taxes and spending. So in the case of deflation, when the economy is growing too slowly or not at all, the government can increase spending and/or cut taxes to help increase consumer demand and spending. The goal of these policies is to put more money in people’s pockets so they’ll spend more, thus increasing demand.

Monetary policy is conducted by a country’s central bank. In the U.S., the Federal Reserve uses monetary policy to control the country’s money supply. It can speed up or slow down inflation by increasing or decreasing the availability of money. So when the country is experiencing deflation, the Federal Reserve might increase the supply of money. They also lower interest rates, making it easier for people to get loans. Not only can individuals get loans more easily to spend money, but businesses can also get loans to hire more people and grow their operations.

What is a historical example of deflation?

Perhaps the most infamous example of deflation is the Great Depression, which began with the stock market crash on September 4, 1929. The inflation rate during those years dropped to a negative number, at times falling below -10%.

Many people were either laid off or were not getting paid enough, meaning they didn’t have money to spend. The unemployment rate during the Great Depression reached nearly 25%. The growth of the Gross Domestic Product (GDP), which is the value of all goods and services produced, fell below zero in the years 1930-1933, meaning the value of the country’s production was decreasing.

The Great Depression is a clear example of how the downward spiral of deflation works. And it wasn’t until the fiscal policies of President Franklin D. Roosevelt kicked in that inflation started to grow again, accompanying a decrease in unemployment and an increase in the GDP.

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