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. (See also: Why Didn't Quantitative Easing Lead to Hyperinflation?)
But what's the deal with deflation?
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? (See also: What Impact Does Inflation and Deflation Have on a Blue-chip Stock Value?)
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. (For more, see: How Unconventional Monetary Policy Works.)
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 government to operate at full capacity.
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.