Typically, deflation is a sign of a weakening economy. Economists fear deflation because falling prices lead to lower consumer spending, which is a major component of economic growth. Companies respond to falling prices by slowing down their production, which leads to layoffs and salary reductions. This further lowers demand and prices.

However, for a period of approximately five years, prices of consumer goods went down in Switzerland without any widespread negative impact on the country's economy. In fact, their economy prospered in the midst of falling prices. This has caused some economists to revise their opinion about the ill effects of deflation, with some arguing that as long as there isn't too much deflation, consumers, and producers in an economy can find an equilibrium.

Key Takeaways

  • For a period of approximately five years, prices of consumer goods went down in Switzerland without any widespread negative impact on the country's economy, leading some economists to revise their opinion about the ill effects of deflation.
  • After researching deflationary periods in the United States, Britain, and Germany during the late 19th century, a team of economists from the National Bureau of Economic Research (NBER) made the claim that deflation can be more positive than negative in a paper issued in February 2004.
  • Deflation is not always a sign of an aggregate demand shortfall and economic weakness; in some cases, deflation can be the result of increased supply from improvements in productivity, greater competition in the goods market, or cheaper and more abundant inputs, such as labor or goods like oil.

The Switzerland Case for Deflation 

In early 2015, Switzerland's central bank introduced negative interest rates in an attempt to curb investor demand for the country's overvalued currency. The debt crises in neighboring countries, in combination with economic instability in Eastern Europe economies, had driven up demand for the Swiss franc by investors looking for a currency safe haven.

In the aftermath, economists expected the Swiss economy to go into a recessionary tailspin. On the contrary, the economy grew and the country posted a low unemployment rate of 3.3% in 2016. Overall, the country experienced a net increase in spending power.

Typically, when a country is experiencing a deflationary period, prices fall as a result of less consumer demand. Lower consumer demand leads to an increase in unemployment. In addition, the ratio of public debt to gross domestic product (GDP) increases as the government is forced to spend more money on social welfare programs. Deflation can push an economy into a recession. However, this was not the case in Switzerland.

Is There Such a Thing as Good Deflation?

Although the general consensus is that deflation is bad for a country's economy, economic research is divided on the issue. In a paper issued by The National Bureau of Economic Research (NBER) in February 2004 (NBER Working Paper No. 10329), titled "Good Versus Bad Deflation: Lessons from the Gold Standard Era," authors Michael Bordo, John Landon Lane, and Angela Redish consider deflationary periods in the United States, Britain, and Germany during the late 19th century. Surprisingly, these economists make the claim that deflation can be more positive than negative.

According to these economists, good deflation occurs when the aggregate supply of goods outstrips aggregate demand. This can be the result of advances in technology or improved productivity. Bad deflation occurs when aggregate demand falls faster than any growth in aggregate supply. Negative money shocks, like what happened during the Great Depression, create "bad" deflation. When monetary neutrality is maintained despite negative money shocks, the impact of deflation can be neutral.

Good Deflation Is Driven by Supply

In March 2015, a team of researchers at the Bank of International Settlements (BIS) published "The Costs of Deflations: a Historical Perspective." These researchers tested the historical link between output growth and deflation in a sample covering 140 years and for up to 38 economies. They concluded that the link is statistically weak or insignificant, and the prevalence of this theory in economics is a result of the events of the Great Depression.

In some contexts, deflation can inhibit strong, sustainable economic growth. But like the economists at NBER, these researchers make the claim that deflation is not always a sign of an aggregate demand shortfall and economic weakness. In some cases, deflation can be the result of increased supply from improvements in productivity, greater competition in the goods market, or cheaper and more abundant inputs, such as labor or goods like oil.

When deflation is driven by supply, prices are depressed but incomes and output (as in GDP) increases. This can create a positive situation for the economy. BIS's research goes on to reveal that asset price deflations and housing price deflations have been more damaging to the economy than a rise in the price of consumer goods and services.

The Cost of Deflation

The best way to respond to deflation when it does present an economic loss is a challenging policy question that economists are still trying to answer. However, the view that deflation is always a symptom of a struggling economy may not be true, though it is deep-seated in economic theory.

This belief is primarily the result of studying the Great Depression, which cannot be considered the archetypal example of what happens during persistent deflationary periods. Rather, according to economists, this period in economic history can be viewed as an outlier.