Deflation is a scenario where there are falling prices of goods and services across the economy. Although the ability to purchase goods and services at a discount may sound like an ideal situation, it has the potential to cause a lot of problems throughout the economy. Some of the negative side effects of deflation are a decrease in consumer spending, increased interest rates, and an increase in the real value of debt.

Key Takeaways

  • Deflation is a scenario where there are falling prices of goods and services across the economy.
  • When deflation is occurring, businesses and consumers often slow their spending since they expect prices to fall further.
  • Deflation can cause a recession or slowdown in economic growth since consumer and business spending are two key drivers for growth.
  • Deflation is the opposite of inflation, which represents widespread price increases of goods and services in an economy.

How Deflation Works

When deflation is occurring, consumers often slow their spending since they expect prices to fall further. Businesses too, delay spending, which can lead to a slowdown in economic growth since consumer and business spending are two key drivers for growth.

Deflation tightens the money supply because there's an increase in real interest rates, causing consumers to save money. It hinders the revenue growth of firms, causing workers to get paid lower wages or potentially laid off. This cycle leads to higher unemployment rates and lower growth rates.

Deflation is the opposite of inflation, which represents widespread price increases of goods and services in an economy.

Real Value of Debt

All of these problems can increase the real value of debt. During times of deflation, since the money supply is tightened, there is an increase in the value of money, which increases the real value of debt. Most debt payments, such as mortgages, are fixed, and when prices fall during deflation, the cost of debt remains at the old level. In other words, in real terms–which factors in price changes–the debt levels have increased.

As a result, it can become harder for borrowers to pay their debts. Since money is valued more highly during deflationary periods, borrowers are actually paying more because the debt payments remain unchanged.

Example of Deflation's Impact on the National Debt

Let's say as an example, the government of Greece owed $100 billion to the United States in the previous year. Thinking in terms of oil, the government could have bought 100 million barrels of oil. However, this year, Greece is experiencing a deflationary period and could buy 200 million barrels of oil with the same amount, since the prices of goods and services have decreased. However, its debt has stayed the same, but now the country is actually paying more–200 million barrels of oil as opposed to 100 million. In other words, after deflation, Greece would be paying the U.S. 200 million barrels of oil worth of money to pay their debt. As a result, deflation can cause the real value of national debt to rise.