A:

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 common problems of deflation are a decrease in consumer spending, increased interest rates and an increase in the real value of debt.

Deflation

When deflation is occurring, consumers often slow their spending, thinking prices will fall further. This leads to a lag in the economic growth and pressures the economy as a whole. Deflation tightens the money because there are increased 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 leads to higher unemployment rates and lower growth rates.

Real Value of Debt

All of these problems can increase the real value of debt. During times of deflation, since money supply is tightened, there is an increase in the value of money, which increases the real value of debt. This makes it 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.

For example, suppose 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 decreases. Its debt stayed the same, but now it is actually paying more – 200 million barrels of oil as opposed to 100 million. Deflation can cause the real value of national debt to rise.

RELATED FAQS
  1. What is the Difference Between Inflation and Deflation?

    Determine how inflation and deflation affects prices, employment, loans, and banks. Learn why economies frequently teeter ... Read Answer >>
  2. Were there any periods of major deflation in U.S. history?

    Learn about major periods of price deflation in the United States, particularly in the 19th century, when falling prices ... Read Answer >>
  3. What is the difference between deflation and disinflation?

    Learn what deflation and disinflation are, the differences between them, and how supply and demand affect price levels. Read Answer >>
  4. How does monetary policy influence inflation?

    Take a deeper look at how contemporary central banks attempt to target and control the level of inflation through monetary ... Read Answer >>
Related Articles
  1. Insights

    The Upside of Deflation

    Deflation has continued to pop up throughout economic history—but is that such a bad thing?
  2. Insights

    Is Europe Stuck With Deflation?

    Mario Draghi, President of the ECB, hopes that driving the deposit rate further into negative territory and purchasing sovereign and corporate bonds will help Europe avoid the scourge of deflation ...
  3. Insights

    How the Eurozone's Fight Against Deflation Is Hurting Savers

    The European Central Bank is fighting a desperate battle against deflation. Find out what it is doing and how it is going to affect savers.
  4. Investing

    Amazon Blamed for Japan's Deflation Problem

    The e-commerce giant is said to have triggered fierce competition between online and offline retailers by driving down retail prices.
  5. Insights

    Macroeconomic Forces That Will Control Markets in 2016

    Learn why several basic macroeconomic factors will control the direction of stock and bond markets in 2016.
  6. Insights

    The Top 6 Ways Governments Fight Deflation

    Here are six monetary and fiscal policy tools that governments use to fight deflation.
  7. Tech

    Why Cash Could Be Your Best Bet

    Holding too much cash in your portfolio is usually a bad thing, but these aren't usual times.
  8. Investing

    An ETF for Dollar Bulls: PowerShares UUP

    A look at PowerShares US Dollar Index Bullish Fund ETF.
  9. Investing

    Top Short-Leveraged Oil ETFs and ETNs

    Think oil will continue to be volatile? These leveraged ETFs and ETNs may provide investors with a chance for attractive returns if oil prices move in the right direction.
  10. Insights

    Is U.S. Inflation on the Horizon?

    Inflation, or the general price level of all goods and services in an economy, has remained subdued in the years following the Great Recession. Given recent developments, is the U.S. on the verge ...
RELATED TERMS
  1. GDP Price Deflator

    The GDP price deflator is a system that converts output measured ...
  2. Gross National Product (GNP) Deflator

    Gross national product deflator is a economic metric that accounts ...
  3. Central Bank

    The entity responsible for overseeing the monetary system for ...
  4. Inflation

    Inflation is the rate at which the general level of prices for ...
  5. Debt Service

    Debt service is the cash that is required for a particular time ...
  6. Debt

    Debt is an amount of money borrowed by one party from another, ...
Trading Center