A:

Deflation impacts consumers positively in the short term but negatively in the long term. In the short term, deflation essentially increases the purchasing power of consumers as prices fall. Consumers can save more money as their income increases relative to their expenses. This also alleviates debt burdens as consumers are able to deleverage.

While falling prices sounds like a good deal for consumers, the factors contributing to deflation are disastrous for consumers and the entire economy over the long term. There is a temporary lull when consumers' income remains steady while prices decline. Eventually, the falling prices begin to affect companies that are forced to slash pay and employment in response to falling revenue. This results in incomes declining and consumer confidence sliding.

This leads to decreased spending, which further pushes firms to cut prices to sell their products. Further, deflationary environments create incentives for consumers and businesses to put off spending money in expectation of falling prices. This rational behavior, on an individual level, feeds into economic weakness, as consumption is a primary driver of economic activity.

During these environments, debt loads and interest payments remain constant. They do not decline despite decreases in incomes. On a relative basis, these are actually increasing and eating up larger portions of household budgets. Many consumers are forced into bankruptcy during these environments and lose any assets that are purchased on credit, such as stocks, homes or automobiles.

Consumers on fixed incomes or those who are fortunate enough to not lose employment or have their pay cut may not face these difficulties. Nevertheless, they will be part of an environment in which their neighbors will be suffering and businesses will be shutting down. The Great Depression is the last time when the world faced entrenched deflation that persisted for years. This experience has taught central banks the necessity of fighting deflation at all costs.

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RELATED TERMS
  1. Value Deflation

    Value deflation happens when companies reduce the size or quality ...
  2. Purchasing Power

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  3. Income Effect

    The income effect is the change in demand for a good or service ...
  4. Consumer Interest

    Consumer interest is any interest charge on personal loans, including ...
  5. Consumer Goods

    Consumer goods are the products purchased by the average consumer. ...
  6. Inflation

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