A:

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.

RELATED FAQS
  1. Are there any economic arguments in favor of deflation?

    Learn about the arguments in favor of deflation and why some people feel it is a good thing despite being almost universally ... Read Answer >>
  2. What can cause price deflation?

    Learn what price deflation is, how inflation rates can be calculated using the consumer price index and what some causes ... Read Answer >>
  3. What causes negative inflation or deflation?

    Find out what deflation is, what causes it, how it hurts the economy and how it can lead to a worsening cycle of deflation ... Read Answer >>
  4. What impact would deflation have on the national debt?

    Learn what deflation is, common problems of deflation and the impact that deflation can have on an economy and a country's ... Read Answer >>
  5. What is the difference between inflation and deflation?

    Determine how inflation and deflation affect prices and employment. Economies frequently teeter between these two economic ... Read Answer >>
Related Articles
  1. Insights

    What is Deflation?

    Deflation is an economic term used to describe a period of declining prices for goods and services. Decreases in the money supply, government spending, consumer demand and business investment ...
  2. Insights

    Can Deflation Be Good?

    General economic theory consensus rules that deflation is bad for the economy. But the Swiss economy, which is growing despite a drop in prices for the last four years, is proving otherwise. ...
  3. Insights

    What's The Difference Between Inflation And Deflation?

    Inflation occurs when the prices of goods and services rise. Deflation occurs when prices decrease.
  4. Insights

    Why is Deflation Bad for the Economy?

    Deflation can adversely affect the economy in significant ways.
  5. Investing

    The Upside Of Deflation

    Deflation has continued to pop up throughout economic history - but is that such a bad thing?
  6. Insights

    Why Deflation Is The Fed's Worst Nightmare

    The measures taken by central banks seem to be winning the battle against deflation, but it is too early to tell if they have won the war.
  7. Investing

    Protect Your Portfolio Against Inflation And Deflation

    Inflation and deflation are opposite sides of the same coin. When both are threatening, here's what to do to keep your portfolio safe.
  8. Insights

    How the Eurozone's Fight Against Deflation Is Hurting Savers

    The European Central Bank is fighting a desperate battle against deflation. Find out what it is doing and how it is going to affect savers.
  9. Insights

    The Dangers Of Deflation

    We look at what life would be like in a deflationary environment, and what you can do to protect your investments.
  10. Insights

    Is Europe Stuck With Deflation?

    Mario Draghi, President of the ECB, hopes that driving the deposit rate further into negative territory and purchasing sovereign and corporate bonds will help Europe avoid the scourge of deflation ...
RELATED TERMS
  1. Deflation

    A general decline in prices, often caused by a reduction in the ...
  2. Debt Deflation

    A situation in which the collateral used to secure a loan (or ...
  3. Value Deflation

    When companies cut their costs without increasing prices for ...
  4. GDP Price Deflator

    An economic metric that accounts for inflation by converting ...
  5. Gross National Product (GNP) Deflator

    An economic metric that accounts for the effects of inflation ...
  6. Deflationary Spiral

    A deflationary spiral is when a period of decreasing prices (deflation) ...
Hot Definitions
  1. Stop-Loss Order

    An order placed with a broker to sell a security when it reaches a certain price. A stop-loss order is designed to limit ...
  2. Acid-Test Ratio

    A stringent indicator that indicates whether a firm has sufficient short-term assets to cover its immediate liabilities. ...
  3. Floating Exchange Rate

    A country's exchange rate regime where its currency is set by the foreign-exchange market through supply and demand for that ...
  4. Taxes

    An involuntary fee levied on corporations or individuals that is enforced by a level of government in order to finance government ...
  5. Impaired Asset

    A company's asset that is worth less on the market than the value listed on the company's balance sheet. This will result ...
  6. Solvency Ratio

    One of many ratios used to measure a company's ability to meet long-term obligations. The solvency ratio measures the size ...
Trading Center