Deflationary Spiral

Loading the player...

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.

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. Monetary Policy

    Monetary policy is the actions of a central bank, currency board ...
  4. Negative Interest Rate Policy (NIRP)

    A negative interest rate policy (NIRP) is an unconventional monetary ...
  5. Expansionary Policy

    A macroeconomic policy that seeks to expand the money supply ...
  6. Inflation

    The rate at which the general level of prices for goods and services ...
Related Articles
  1. Personal Finance

    Why is Deflation Bad for the Economy?

    Deflation can adversely affect the economy in significant ways.
  2. Markets

    Do Deflationary Shocks Help Or Hurt The Economy?

    Find out how deflationary shocks can both benefit and hurt consumers and businesses.
  3. ETFs & Mutual Funds

    The Upside Of Deflation

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

    The Top 6 Ways Governments Fight Deflation

    Here are six monetary and fiscal policy tools that governments use to fight deflation.
  5. Markets

    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 ...
  6. Markets

    What's The Difference Between Inflation And Deflation?

    Inflation occurs when the prices of goods and services rise. Deflation occurs when prices decrease.
  7. Markets

    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. ...
  8. Markets

    Is U.S. Inflation on the Horizon?

    Inflation, or the general price level of all goods and services in an economy, has remained subdued in the years following the Great Recession. Given recent developments, is the U.S. on the verge ...
  9. Markets

    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.
  10. 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.
RELATED FAQS
  1. What is a deflationary spiral?

    Learn the meaning of a deflationary spiral and its causes; the last deflationary spiral was the Great Depression. QE has ... Read Answer >>
  2. 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 >>
  3. 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 >>
  4. 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 >>
  5. 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 >>
  6. 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 >>
Hot Definitions
  1. Duration

    A measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. ...
  2. Dove

    An economic policy advisor who promotes monetary policies that involve the maintenance of low interest rates, believing that ...
  3. Cyclical Stock

    An equity security whose price is affected by ups and downs in the overall economy. Cyclical stocks typically relate to companies ...
  4. Front Running

    The unethical practice of a broker trading an equity based on information from the analyst department before his or her clients ...
  5. After-Hours Trading - AHT

    Trading after regular trading hours on the major exchanges. The increasing popularity of electronic communication networks ...
  6. Omnibus Account

    An account between two futures merchants (brokers). It involves the transaction of individual accounts which are combined ...
Trading Center