Deflation is a decrease in the general price level of goods and services in a country. It is the opposite of inflation, which is when general price levels in a country are rising. In the short-term, deflation impacts consumers positively because it increases their purchasing power, allowing them to save more money as their income increases relative to their expenses. Deflation also alleviates debt burdens because consumers are able to deleverage. However, in the long-term, deflation negatively impacts consumers. The last time the world experienced an entrenched period of deflation that lasted for many years was the Great Depression.

Key Takeaways

  • In the short-term, deflation impacts consumers positively because it increases their purchasing power, allowing them to save more money as their income increases relative to their expenses.
  • In the long-term, deflation creates higher rates of unemployment and can eventually cause consumers to default on their debt obligations.
  • The last time the world experienced an entrenched period of deflation that lasted for many years was the Great Depression.

Consumer Price Index (CPI) Measures Deflation

In the U.S., the Consumer Price Index (CPI) is the most common method for evaluating inflation rates (and conversely, deflation rates). Most countries compare changes in consumer prices by comparing the change in the price of a basket of diverse goods and products to an index. The CPI is the most commonly referenced index in the U.S. The economy is experiencing deflation when the change in prices in one period is lower than the next, revealing that the CPI index has declined.

Deflation Upends Economic Growth and Stability

When there are small drops in the prices of certain products, such as food or energy, this can be good for the economy because it has a positive effect on consumer spending. However, a widespread fall in prices presents a very severe, negative situation for economic growth and stability in the long-term. Over time, the factors that contribute to deflation are disastrous for consumers and for the economy. Deflation typically occurs during or after economic crises. During a recession or depression, consumption and investment activity decreases, impacting the overall output of the economy.

Deflation Creates Higher Rates of Unemployment

At the beginning of a deflationary period, there is a temporary lull when consumers' income remains steady while prices decline. Eventually, these falling prices begin to have an impact on the health of companies. In response to falling revenue, companies are forced to cut pay and layoff workers. This results in increased unemployment, incomes declining and consumer confidence decreasing. When incomes decline and confidence is lowered, consumers decrease their spending. This creates another situation where companies are pushed to cut their prices in order to sell their products.

Debt Increases Relative to Household Budgets

Despite decreases in incomes, debt loads and interest payments remain constant during periods of deflation. However, on a relative basis, debt and interest payments increase because they eat up a larger portion of household budgets. Individuals who become unemployed may have a hard time finding new employment and may spend their savings in order to survive. Many consumers are forced into bankruptcy during periods of deflation. Consumers may also lose any assets that are purchased on credit, such as homes or automobiles, and default on student loans and credit card payments.

Deflationary Periods Are Dangerous for the Economy

Consumers on fixed incomes, and individuals who do not lose employment or have their pay cut, may be spared financial difficulties during deflationary periods. However, a deflationary period is dangerous for a country's economy and even individuals who are spared economic hardships themselves will be living in an environment where businesses are closing and people in their community are economically displaced.