Deflationary Spiral

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DEFINITION of 'Deflationary Spiral'

A deflationary spiral is when a period of decreasing prices (deflation) leads to a situation whereby the economy cannot recover, which compounds over time leading to even lower prices in a vicious cycle.

Deflation occurs when the general price levels decline, as opposed to inflation which is when general prices levels rise. When deflation occurs, central banks and monetary authorities can enact expansionary monetary policies to spur demand and economic growth. If monetary policy efforts fail, however, due to greater than anticipated weakness in the economy or because target interest rates are already zero or close to zero, a deflationary spiral may occur even with an expansionary monetary policy in place.

BREAKING DOWN 'Deflationary Spiral'

Deflation typically occurs during periods of economic crisis such as a recession or depression as economic output slows and demand for investment and consumption dries up. This may lead to an overall decline in asset prices as producers are forced to liquidate inventories that people no longer want to buy. Consumers and businesses alike begin holding on to liquid money reserves to cushion against further financial loss. As more money is saved, less money is spent, further decreasing aggregate demand. At this point, people's expectations regarding future inflation are also lowered and they begin to hoard money. Why would you spend a dollar today when the expectation is that it could buy effectively more stuff tomorrow? And why spend tomorrow when things may be even cheaper in a week's time?

In a recession, demand decreases and companies produce less. Low demand for a given supply equals low prices. As production cuts back to accommodate the lower demand, companies reduce their workforce resulting in an increase in unemployment. These unemployed individuals may have a hard time finding new work during a recession and will eventually deplete their savings in order to make ends meet, eventually defaulting on various debt obligations such as mortgages, car loans, student loans and on credit cards. The accumulating bad debts ripple through the economy up to the financial sector who must write them off as losses. Financial institutions begin to collapse, removing much needed liquidity from the system and also reducing the supply of credit to those seeking new loans.