Deflation is a concept most investors don't really understand. The word is sometimes discussed in the financial media, usually in ominous terms, with some pundit invoking images of the Great Depression and warning about the impending arrival of deflation in the United States. The truth is that deflation has both good and bad effects on a society and economy, but like anything, too much is usually a bad thing.

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What Is It?
Deflation is defined in its simplest form as a general decline in prices caused by a contraction in the amount of money or credit. Most will recognize this as the opposite of inflation, a word that public tends to better understand.

Fears of deflation have been stoked by the latest report from the government on consumer prices. In April 2010, the Consumer Price Index declined by 0.1%, and excluding the food and energy components, the index was flat for the month. This core index, which excludes food and energy prices, has risen by only 0.9% over the last 12 months, the lowest since the early 1960s. (For background reading, see The Upside Of Deflation and Deflationary Shocks:Helping Or Hurting The Economy?)

The Good Side
The good side of deflation must be fairly obvious to most people. Who wouldn't want the prices of consumer goods to go down rather than move higher? Some industries have been in deflation mode for years. Just think about buying a personal computer; the machine you can buy today with $500 is leagues ahead of what that sum would have bought 10 years ago.

This deflation is the result of improved productivity by companies, or a technological breakthrough that led to a lower cost structure in manufacturing. This process is what guides Moore's Law for semiconductors, which posits that the number of transistors on a semiconductor will double every two years.

The Bad Side
On the other hand, deflation can lead to dire economic results in some circumstances. What if consumers were convinced that prices would continue to fall, and then delayed purchases in anticipation of this? Why buy that new car now if you thought that in six months you might be able to buy it for $500 less?

This type of consumer behavior is detrimental in the long run, and can lead to lower demand and production by businesses, causing swelling inventories, higher unemployment and a contracting economy.

Historical Deflation
The United States has experienced deflation in the past, although it was so long ago that the experience has left the public consciousness. During the Great Depression, there were waves of banking panics across the United States. Many depositors withdrew funds from banks rather than risk losing the money in a bank failure; this led to a reduction in reserves against which banks could lend, and a contraction in credit. This eventually cause spending on goods and services to drop, contributing to a severe contraction in the economy. (To learn more, see What Caused The Great Depression?)

Debt Deflation
Another unpleasant side effect of deflation is the impact on debt. Since price levels are falling, a dollar is worth more in the future than it is today, the opposite of inflation. This benefits lenders since the payments made to them will be worth more in the future. Thus, deflation increases the real cost of a nominal debt.

While deflation is certainly a threat, the government has more tools to fight deflation, and a much more sophisticated understanding of how the economy works. As such, it's probably safe to assume that it wouldn't make the same mistakes that it made back in the 1930s.

The Bottom Line
Deflation is not always bad for an economy or society as long as it does not get too far out of control. This is something that our economic policy-makers are watching closely so that they don't repeat mistakes made during previous eras of deflation.

Catch up on the latest financial news in Water Cooler Finance: Buffett Speaks Up, AIG Deal Collapses.

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