What is Deflation?

Deflation is when the prices for goods and services decline across the board, usually because there's less money and credit supply in the economy. When deflation kicks in, your money actually becomes more valuable over time. As a result, your cash stretches further, letting you buy more with the same amount of money.

Synonyms

• Decrease in Prices
• Reduction in Inflation
• Deflationary Trend

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The Causes of Deflation

Economists say there are two major reasons for deflation in an economy:

1. A drop in overall demand

When the overall demand drops, it causes prices of goods and services to fall. There are some factors behind this drop in demand:

• Fall In The Money Supply

This happens when a central bank tightens monetary policy by raising interest rates. People are more likely to save their money rather than spend it right away. In addition, higher interest rates make borrowing more expensive, which means people are less willing to spend their money and also discourages spending in the economy.

• Decline In Confidence

When the economy takes a downturn—such as during a recession—people tend to get more worried about the future. Subsequently, they prefer to save more and spend less, which can lead to a drop in overall demand.

2. An increase in overall supply

Also, when there is an increase in overall supply, this tends to trigger deflation. Producers face fiercer competition and are forced to lower the prices of their products or services. This growth in overall supply is mainly caused by the following factors:

• Lower Production Costs

A decline in price for key production inputs (like oil) will lower production costs. This means producers will be able to make more goods, which will lead to an increase in supply. If demand remains the same, producers will need to lower their prices on goods to keep interested people in buying their products.

• Technological Advances

When technology keeps evolving or new tech gets quickly adopted in production, it can increase the overall supply of goods. This tech progress allows producers to cut their costs, which usually makes product prices likely drop.

The Effects of Deflation

Deflation isn’t all bad. In the short term, it can help customers to buy more with the same paycheck. Beyond this, the negative effects can mount quickly. Below are a few negative effects of deflation:

• Increase in Unemployment

When there is deflation, unemployment tends to go up. When price levels drop, businesses often respond by cutting costs, which usually means laying off some of their employees.

• Increase in the Real Value Of Debt

Deflation often occurs when the interest rate is high, which means that debt will become more expensive in real terms. However, because of this, people are likely to hold off on their spending.

• Less Customer Spending

When people have less money to spend, they tend to buy fewer things they don’t need. This can slow down the economy, further creating a cycle where falling prices lead to even less spending. Another reason people might spend less is that they are waiting for prices to drop further.

• Deflation Spiral

This is a situation where decreasing price levels set off a chain reaction that leads to lower production, lower wages, decreased demand, and even lower price levels. During a recession, the deflation spiral is a significant economic challenge because it further worsens the economic situation.

• More Expensive Debt

If your monthly mortgage or car loan payments are still the same but your income is dropping, you will end up spending a bigger chunk of your paycheck on debt. Meanwhile, the value of what you’re paying off, like your house or car, is decreasing.

How is Deflation Measured?

The Consumer Price Index (CPI) keeps track of the prices of around 80,000 items sold in the U.S. each month, including the sales and excise taxes. Plus, there are smaller indexes that track prices in different regions and cities across the country.

Here's a breakdown of the eight main groups in the CPI:

• Food and beverages
• Medical care
• Housing (rents only)
• Education and communication
• Transportation (including fuel costs)
• Apparel
• Recreation
• Other goods and services

Items like income taxes, social security taxes, stocks, bonds, real estate, and life insurance aren't included in the CPI because they don't have much to do with our day-to-day consumption.