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Deflation

Updated on April 11, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

Deflation Meaning

Deflation is defined as an economic condition whereby the prices of goods and services go down constantly with the inflation rate turning negative. The situation generally emerges from the contraction of the money supply in the economy.

Many economists consider deflation worse than inflation as it is usually accompanied by a fall in the aggregate demandAggregate DemandAggregate Demand is the overall demand for all the goods and the services in a country and is expressed as the total amount of money which is exchanged for such goods and services. It is a relationship between all the things which are bought within the country with their prices.read more, collective wages, investments and employment.

Key Takeaways

Deflation

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Understanding Deflation and its Impact

Deflation is a situation that arises when there is a fall in the general prices of goods and services in an economic system. The fall could result from stagnant growth or due to the central bank’s contractionary monetary policy to restrict the money supply. Deflation is bad for an economy, even though it increases the purchasing power of money.

When prices fall constantly, consumption declines, as people wait for the rates to decrease more to make a cheaper purchase. With more supply and less demand, prices fall further. Less business leads to less income, which forces companies to pay low wages or lay off workers.

Consumer income falls further, and they start saving more for rainy days. This further reduces the aggregate demand. Moreover, debt becomes expensive as less supply of money makes interest rates rise. If not controlled, the situation could fall into a vicious cycle leading to conditions like the Great Depression.

During the Great Depression, the real GDP in the US had declined by 30 %. Also, the Wholesale Price Index (WPI) had fallen by 33%. WPI and Consumer Price Index (CPI) track the retail prices of commonly purchased commodities by households, which helps in measuring inflation and deflation. Therefore, if the CPI is indicating fallen prices from a previous period, it will suggest deflation.

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Causes of Deflation 

  1. A recession struck or stagnant economy gives rise to excessive price fall when unemployment and low wages leave less money in the hands of consumers. They spend less, save more, reducing aggregate demand and investments which leads to fallen prices.
  2. When the central bank of a nation adopts a contractionary monetary policy for extended periods such as interest rate hikes to curb inflation or the excessive money supply, it can cause deflation. Credit becomes expensive with interest hikes, hindering banks’ lending facility causing a cash crunch amongst the public.
  3. A particular segment of the economy can also experience excessive price fall. If there is over production and not a proportionate increase in buyers, it makes the product less expensive due to over-supply and less demand. An example is China’s 2009 crisis in which the economy experienced deflation in factory prices due to price declines globally and over production capacity.
  4. Another prominent reason is perfect competition in a particular industry or sector, which forces entities to reduce product prices to survive the competition. Technology sector is often battling this issue.
  5. The phenomena can stem from reduced production costs as well. The cost of production steeps down because of technological advancement, discovery of newer and cheaper resources. Overall decline in inputs reduces pricing of goods or service.  

Real-World Examples of Deflation

1. In an Economy

This Financial Times report recounts how Japan battled mild deflation throughout the 2000s. It occurred after a troublesome 1990s owing to the housing bubble burst and banking crisis. As a result, its CPI became negative in 1998. Since then, Japan’s efforts have been to bring inflation to 2%. However, even till 2020, Japan’s inflation rate was 0.4 %.

A 2% inflation is widely considered ideal for stimulating economic growth. Therefore, Japan relied on monetary easing methods such as zero interest rates, asset buying, etc., to enhance money circulation. However, many experts suggest falling consumption, high savings and an ageing population hindering Japan’s growth.

2. Within a Financial Sector

A single sector of the economy, such as technology, automobile, factory, etc., also battles with stagnant prices. As the Covid-19 pandemic spread across the world, many of China’s factories slipped into critical deflation.

In April 2020, China saw its Producer Price Index falling by 3.1% than 2019’s figures. Oil price decline, sluggish demand, and falling pork consumption were seen as major contributors to stagnant prices.

How to Tackle Deflation?

When governments undertake deflation curbing measures, the idea is to increase the availability of money in the hands of consumers. Low-income fuels consumer savings as they feel insecure about their financial security.

With enhanced income, consumer spending normally goes up, increasing the aggregate demand and eventually the prices. Businesses start employing more using enhanced profits. Wages and employment rates climb up, bringing the economy back on track.

  1. Central banks can take various measures to promote liquidity by ensuring an increased money supply in the economy. It includes buying back of government securities, cutting down short-term interest rates to enhance banks’ lending and reducing reserve requirements.
  2. For example, in Japan as part of the monetary easing plan, the interest rates were kept near-zero to stimulate borrowing. Additionally, Japan and European Central Bank (ECB) had also brought in negative interest rates. The move encourages banks to lend excess reserve to escape additional charges from the central bank.
  3. Quantitative easing (QE) – Some countries have adopted a QE policy to eliminate sluggish growths by enhancing the money supply. Under QE, central banks issue new money electronically by large scale buying of bonds and other securities from the open market. It is implemented at an advanced stage when standard growth stimulating tools have failed to arrest the economic crisis. Japan has been undertaking QE measures relentlessly for many years to push more money in circulation.
  4. Methods vary as per economies. Japan also introduced yield curve control as part of the QE. This involved keeping the yield on its 10-year government at zero, a move to stimulate banks’ profit.
  5. Besides, the finance ministry introduces fiscal policy reforms like lessening tax rates and escalating public expenditure for ensuring higher disposable income to stimulate spendings.

Deflation vs Inflation vs Disinflation

As we have already discussed, deflation is termed as negative inflation when the commodity prices keep falling and inflation occurs when the prices of commodities are on the rise.

Disinflation is an economic phase that is marked by a reduction in the inflation rate, and it is distinct from deflation, where inflation becomes negative. So, inflation could be rising under disinflation but at a slower pace. Let us take at how these three concepts differ from each other.

BasisDeflationInflationDisinflation
MeaningEconomic slowdown as the prices of goods and services decline.An economic condition where the prices of goods and services increase.Economic correction where the rate of inflation declines.
CausesFall in demand, high supply – low demand, contraction of money supply interest hikes and low investmentIncrease in demand, higher expansion of money supply, low-interest rates and higher investmentContractionary fiscal or monetary measures, recession
EffectsIncreases the purchasing power of money, unemployment, wages cut, poor revenue generation.Decreases the purchasing power of money, high cost of living and widening income gapDecrease in inflation rates but not real inflation.
SolutionExpansionary monetary and fiscal policies.Contractionary monetary and fiscal policies, increase in savings.Implementation of mixed policies.
BenefitsShort-lived fallen prices are beneficial due to the availability of cheaper goods and services.2% inflation is good for economic growth, business profitability and wage incrementGeneral price level stability or gradual price rise, economic growth, and gradual GDP and aggregate demand increase.

FAQ

What is deflation in economics?

Deflation in economics is negative inflation (below 0%) that occurs when a country or an industrial sector experiences a decrease in the price of its products and services due to monetary contraction.

What causes deflation?

The two main reasons behind deflation are:
1. Downfall in demand for goods and services with increased supply: When there is an oversupply than the required demand, it leads to falling prices. Additionally, recession triggers low wages, joblessness, money supply contraction, expensive credit, etc., decreasing consumer income and spending.
2. Inflation controlling measures such as interest rate hikes by the Fed also leads to lesser borrowing and investments, reducing consumers’ purchasing might.

Who benefits from deflation?

Economies at times need to curtail rising prices, especially during extended inflation to enhance affordability. For business, it paves the way towards technological advancement and production scalability due to low cost. As a result, money’s purchasing power also increases.

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