When most of us think of inflation, we think of rising prices that strain budgets and take away our buying power. During the late 1970s and early 1980s, inflation skyrocketed as high as 14.8% in the U.S. and interest rates climbed to similar levels. Few living Americans know what it's like to face the opposite phenomenon - deflation.
TUTORIAL: Economic Indicators To Know
Since too much inflation is generally regarded as a bad thing, wouldn't it follow that deflation might be good thing? Not necessarily, since much depends on the cause and circumstances of the deflationary cycle and how long it lasts. (Deflation has continued to pop up throughout economic history - but is that such a bad thing? Learn more in The Upside Of Deflation.)
What Is It?
Deflation is a general decline in prices as a function of supply and demand for products, and the money used to buy them. Deflation can be caused by a decrease in the demand for products, an increase in the supply of products, excess production capacity, increase in the demand for money, or a decrease in the supply of money or availability of credit.
Decreased demand for products can manifest itself in the form of less personal spending, less investment spending and less government spending. While deflation is often associated with an economic recession or depression, it can occur during periods of relative prosperity if the right conditions are present.
If prices are dropping because a product can be produced more efficiently and cheaply in greater quantity, that's viewed as a good thing. An example of this is consumer electronics which are far better and more sophisticated than ever. Yet prices have consistently dropped as the technology improved and spurred more demand. (Learn more in our Economics Basics Tutorial.)
The effect on prices by fluctuations in the demand for money is usually a function of interest rates. As the demand for money increases during a period of inflation, interest rates rise to compensate for the higher demand and to keep prices from rising further. Conversely, deflation will result in lower interest rates as the demand for money drops. In that case, the goal is to spur buyer demand to stimulate the economy.
The Great Depression
Severe economic contraction during the Great Depression resulted in deflation averaging -10.2% in 1932. As the stock market began to crater in late 1929, the supply of money declined along with it as liquidity was drained from the marketplace.
Once the downward spiral had begun, it fed on itself. As people lost their jobs, this reduced the demand for goods, causing further job losses. The decline in prices wasn't enough to spur demand because rising unemployment undercut consumer purchasing power to a far greater degree. The snowball effect didn't stop there, as banks began to fold as loan defaults rose dramatically.
As banks stopped lending money and credit dried up, the money supply contracted and demand tanked. Although the demand for money remained high, no one could afford it because the supply had shrunk. Once this vicious cycle took hold, it lasted a decade until the beginning of World War II.
There are many reasons to be concerned about a prolonged deflationary period, even without an event as devastating as the Great Depression:
1. Demand for goods decreases since consumers delay purchases, expecting lower prices in the future. This compounds itself as prices drop further in response to decreasing demand.
2. Consumers expect to earn less, and will protect assets rather than spend them. Since 70% of the U.S. economy is consumer-driven, this would have a negative effect on GDP.
3. Bank lending drops since borrowing money makes less sense in regards to the real cost. This is because the loan would be paid back with money that is worth more than it is now.
4. Deflation ensures that borrowers which loot to purchase assets lose since an asset becomes worth less in the future than when it was bought.
5. The more indebted you are, the worse your condition since your salary will likely decline while your loan payments remain the same.
6. During inflation, there is no upper limit on interest rates to control the inflation. During deflation, the lower limit is zero. Lenders won't lend for zero percent interest. At rates above zero, lenders make money but borrowers lose and won't borrow as much.
7. Corporate profits usually drop during a deflationary period, which could cause a corresponding decrease in stock prices. This has a ripple effect to consumers who rely on stock appreciation and dividends to supplement their incomes.
8. Unemployment rises and wages decline as demand drops and companies struggle to make a profit. This has a compounding effect throughout the entire economy.
What to Do
Ever since the Great Depression, there has been a continuing debate on how best to combat recessions and deflation. Federal Reserve Chairman Ben Bernanke has adopted a policy of "quantitative easing," which essentially amounts to printing money to buy U. S. Treasuries. Following Keynesian economic theory, he is using the money supply to offset the economic contraction that resulted from the financial meltdown in 2008 and the bursting of the housing bubble. How this plays out remains to be seen since these policies are designed to cause inflation.
If the U.S. were to enter a sustained deflationary cycle, your best protection is to hold onto your job and have as little debt as possible. You don't want to be locked in to paying off a loan with money that is increasing in value every day. Save as much money as possible and defer discretionary purchases until prices are lower. Finally, consider selling assets that you don't need while they still have value.
EconomicsInvestigate the muddy fiscal policy, tax problems, and inability to institute austerity that created the Greek crises in 2010 and 2015.
Home & AutoRoofing your home is very important, that’s why you should choose a roof specifically designed to handle your area’s climate.
Technical IndicatorsVIX moving averages smooth out the natural choppiness of the indicator, letting traders and market timers access reliable sentiment and volatility data.
Investing NewsWhere is the market going today after yesterday's bumpy ride?
ProfessionalsWhen the stock market sees a steep drop, clients are bound to get anxious. Here are some tips for talking them off the ledge.
Investing BasicsOwning stocks may shortly become too scary for your portfolio. Here's why, and here are some alternatives.
InvestingGlobally and in the United States, stocks are now in correction mode, with the recent erosion in equities in emerging markets and Europe in a bear market.
EconomicsUnderstand how asset bubbles often lead to deep, protracted recessions. Read about historical examples of recessions preceded by asset bubbles.
MarketsUnderstand what the vodka industry is and where it performs best. Learn about the growth of the industry and three reason why it continues to grow.
Investing BasicsThe world's stock markets are shaky, to say the least. Should you hold onto your cash or bargain hunt?
A trade term requiring the seller to arrange for the carriage ...
A bond that is issued for less than its par (or face) value, ...
An international organization created for the purpose of standardizing ...
The rate at which the general level of prices for goods and services ...
A metric used in capital budgeting measuring the profitability ...
A transaction in international trade where the seller is responsible ...
Inflation is, and has been, a highly debated phenomenon in economics. Even the use of the word "inflation" has different ... Read Full Answer >>
The best ways to sell an annuity are to locate buyers from insurance agents or companies that specialize in connecting buyers ... Read Full Answer >>
Argentina is not a developed country. It has one of the strongest economies in South America or Central America and ranks ... Read Full Answer >>
Social Security benefits are adjusted for inflation. This adjustment is known as the cost of living adjustment (COLA). For ... Read Full Answer >>
In macroeconomics, balance of trade is one of the leading economic metrics that determines the trading relationship of a ... Read Full Answer >>
In economics, utility function is an important concept that measures preferences over a set of goods and services. Utility ... Read Full Answer >>