Deflation occurs when the change in prices turns negative. Today, the economies of the Eurozone are combating deflation, and the European Central Bank (ECB) has even been taking the extraordinary measures of undergoing quantitative easing.

But what's the story with deflation?

Key Takeaways

  • Deflation is when the general price levels in a country are falling—as opposed to inflation when prices rise.
  • If deflation occurs, people choose to hold on to savings instead of spending it today, since prices will be lower tomorrow—even lower next week, and even lower in a month.
  • As a result, a vicious cycle can ensue that drags an economy into recession or depression as economic activity grinds to a halt.

Deflation: Causes and Effects

Changes in consumer prices are economic statistics compiled in most nations by comparing changes of a basket of diverse goods and products to an index. In the U.S. the Consumer Price Index (CPI) is the most commonly referenced index for evaluating inflation rates. When the change in prices in one period is lower than in the previous period, the CPI index has declined, indicating that the economy is experiencing deflation.

One might think that a general decrease in prices is a good thing because it gives consumers greater purchasing power. To some degree, moderate drops in certain products, such as food or energy, do have some positive effect on consumer spending. A general, persistent fall in prices, however, can have severe negative effects on growth and economic stability. 

Recessions and Deflation

Deflation typically occurs in and after periods of economic crisis. When an economy experiences a severe recession or depression, economic output slows as demand for consumption and investment drop.

This leads to an overall decline in asset prices as producers are forced to liquidate inventories that people no longer want to buy. Consumers and investors alike begin holding onto 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 about future inflation are 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?

Deflation's Vicious Cycle

As production slows down to accommodate the lower demand, companies reduce their workforce, increasing unemployment. These unemployed individuals may have a hard time finding new work during a recession and will likely deplete their savings to make ends meet, eventually defaulting on various debt obligations such as mortgages, car loans, student loans, and credit cards.

The accumulating bad debts ripple through the economy up to the financial sector that must write them off as losses. As banks' balance sheets become shakier, depositors seek to withdraw their funds as cash in case the bank fails.

A bank run may ensue, whereby too many deposits are redeemed, and the bank can no longer meet its own obligations. Financial institutions begin to collapse, removing much-needed liquidity from the system and also reducing the supply of credit to those seeking new loans.

Central banks often react by enacting a loose, or expansionary, monetary policy. This includes lowering the interest rate target and pumping money into the economy through open market operations—buying Treasury securities in the open market in return for newly created money.

If these measures fail to stimulate demand and spur economic growth, central banks may undertake quantitative easing by purchasing riskier private assets in the open market. The central bank can also step in as a lender of last resort if the financial sector is severely hindered by such events.

Governments will also employ an expansionary fiscal policy by lowering taxes and increasing government spending. However, the problem with lowering taxes in a period of low prices and high unemployment is that overall tax revenues will decrease, limiting the ability of the government to operate at full capacity.

Deflationary Spiral

A deflationary spiral is when this cycle gets out of control. It 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.

Consumers have less incentive to spend money today when they can reasonably expect that their money will have more purchasing power tomorrow.

The Bottom Line

A little bit of inflation is good for economic growth—around 2% to 3% a year. But, when prices begin to fall after an economic downturn, deflation may set in causing an even deeper and more severe crisis. 

As prices fall, production slows and inventories are liquidated. Demand drops and unemployment increases. People choose to hoard money rather than spend because they expect prices to drop even more in the future. Defaults on debt increase, and depositors withdraw cash en masse, causing a financial meltdown defined by a lack of liquidity and credit. Central banks and governments react to stabilize the economy and incentivize demand through expansionary fiscal and monetary policy, including unconventional methods such as quantitative easing.

All in all, a deflationary period is dangerous for a country's economy.