Deflation vs. Disinflation: An Overview

Although they may sound the same, deflation should not be confused with disinflation. Deflation is a decrease in general price levels of throughout an economy, while disinflation is what happens when price inflation slows down temporarily.

Deflation, which is the opposite of inflation, is mainly caused by shifts in supply and demand. Disinflation, on the other hand, shows the rate of change of inflation over time. The inflation rate is declining over time, but it remains positive.

Key Takeaways

  • Deflation is the drop in general price levels in an economy, while disinflation occurs when price inflation slows down temporarily.
  • Deflation, which is harmful to an economy, can be caused by a drop in the money supply, government spending, consumer spending, and corporate investment.
  • Central banks will fight disinflation by expanding its monetary policy and lowering interest rates.
  • Disinflation can be caused by a recession or when a central bank tightens its monetary policy.

Deflation

Deflation is the economic term used to describe the drop in prices for goods and services. Deflation slows down economic growth. It normally takes place during times of economic uncertainty when there is demand for goods and services is lower, along with higher levels of unemployment. When prices fall, the inflation rate drops below 0 percent.

Deflation (and inflation) rates can be calculated using the consumer price index (CPI). This index measures the changes in the price levels of a basket of goods and services. They can also be measured using the gross domestic product (GDP) deflator, which measures the price inflation.

There are several different factors that can cause deflation, including a drop in the money supply, government spending, consumer spending, and investment by corporations.

Business productivity can also lead to a drop in prices. When a company uses more advanced technology in its production process, it may become more efficient, thereby reducing its costs. These cost savings may then be passed on to the consumer resulting in lower prices.

Consider the case of mobile phones. Cellphone prices have dropped significantly since the 1980s due to technological advances. This has allowed supply to increase at a faster rate than the money supply or demand of cellphones.

But bonds can perform well during times of deflation. More investors end up flocking to quality assets that promise a safer investment vehicle. By contrast, it can have a negative effect on the stock market. A drop in prices—and, therefore, supply and demand—will hurt the profitability of companies, leading to the erosion of share value.

In order to deal with deflation, a central bank will step in and employ an expansionary monetary policy. It lowers interest rates and increases the money supply within the economy. This, in turn, boosts demand for goods and services. Lower interest rates mean an increase in the spending power of consumers. More spending means price inflation and, therefore, higher demand for goods and services. Higher prices lead to higher profits for businesses.

Disinflation

Disinflation occurs when price inflation slows down temporarily. This term is commonly used by the U.S. Federal Reserve when it wants to describe a period of slowing inflation. Unlike deflation, this is not harmful to the economy because the inflation rate is reduced marginally over a short-term period.

Unlike inflation and deflation, disinflation is the change in the rate of inflation. Prices do not drop during periods of disinflation and it does not signal an economic slowdown. While a negative growth rate—such as -2 percent—indicates deflation, disinflation is demonstrated by a change in the inflation rate from one year to the next. So disinflation would be measured as a change of 4 percent from one year to 2.5 percent in the next.

Disinflation isn't necessarily bad for the stock market, as it may be during periods of deflation. In fact, stocks can perform well when the inflation rate drops.

Disinflation is caused by several different factors. A recession or a contraction in the business cycle may result in disinflation. It may also be caused by the tightening of monetary policy by a central bank. When this happens, the government may also begin to sell some of its securities, and reduce its money supply.