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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 have all been cited as causes of deflation.

Deflation usually happens during an economic depression when there is lower demand for goods and services and higher levels of unemployment.  To counteract deflation in the United States economy, the Federal Reserve Bank (the Fed) uses its monetary policy powers to increase the money supply.  An increase in the money supply can stimulate spending.  The increased spending can cause price inflation as demand for goods and services increases.

The Fed is most noted for using its monetary powers to counter inflation.  However, it is equally wary of chronic, persistent deflation, such as Japan’s situation in the 1990s.  The Japanese banks lowered interest rates to zero to combat deflation.  It took until 2006, however, for this move to start restoring the Japanese economy.  

Continued, rapid deflation can cause a circular domino effect of lower profits, bankrupt businesses, layoffs and high unemployment. Lower income would lead to lower demand for goods and services, meaning prices would drop -- lowering profits still further -- and the cycle would continue.  The Fed has been able to avoid this scenario through strategic implementation of monetary policy.

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