Before we delve right into the topic of deflation, it should be noted that the causes and effects of deflation are complex economic forces. In this answer, we'll simply introduce readers to the concept and explain how it affects investors.

Deflation is a macroeconomic condition where a country experiences lowering prices. This is the opposite of inflation which is characterized by rising prices (do not confuse deflation with disinflation, which is simply a slowing of inflation). To many economists, deflation is more serious than inflation because deflation is more difficult to control. Let's take a look at the different effects of deflation.

One would think that people would be happier if prices were to go down. Everything becomes cheaper, and the money that we have seems to go a little further than it used to. However, when this effect drags on for too long, companies' profits begin to decline. Economic conditions (i.e. excess supply) force companies to sell their products for even cheaper and subsequently cut back on production costs, reduce employee wages, lay off workers or even close production facilities. At this point, unemployment will increase, the economy cannot expand and people aren't spending their money because their economic future seems uncertain.

Equity prices begin to decline as people sell off their investments, which are no longer offering good returns, and bonds temporarily become more attractive. Until the government can find a way to increase consumer and business spending - usually by lowering interest rates to stimulate the economy - equity prices will take a severe beating.

Now that you know the effects of deflation, you can imagine why it is considered worse than inflation: in times of inflation, governments curb spending and encourage saving by increasing interest rates, but as governments will do the opposite to encourage spending during deflation, they cannot lower the nominal interest rates to a negative level, or below zero. Central banks in areas affected by deflation can only move the rate by a certain amount.

If you would like to learn more about deflation, a great place to start is our Inflation Tutorial.

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  6. Monetary Policy

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