What is Deflation?

Deflation, or negative inflation, happens when prices generally fall in an economy. This can be because the supply of goods is higher than the demand for those goods, but can also have to do with the buying power of money becoming greater.. Buying power can grow due to a reduction in the money supply, as well as a decrease in the supply of credit, which has a negative effect on consumer spending.

Key Takeaways

  • Deflation is the general decline of the price level of goods and services.
  • Deflation is usually associated with a contraction in the supply of money and credit, but prices can also fall due to increased productivity and technological progress.
  • Deflation incentivizes people to hoard cash because they can buy relatively more with a dollar in the future than now - this has negative feedback loops that can lead to economic depression..

 Causes of Deflation

Deflation can be caused by a combination of different factors, including having a shortage of money in circulation, which increases the value of that money and, in turn, reduces prices; having more goods produced than there is demand for, which means businesses must decrease their prices to get people to buy those goods; not having enough money in circulation, which causes those with money to hold on to it instead of spending it; and having a decreased demand for goods overall, therefore decreasing spending.

By definition, monetary deflation can only be caused by a decrease in the supply of money or financial instruments redeemable in money. In modern times, the money supply is most influenced by central banks, such as the Federal Reserve. When the supply of money and credit falls, without a corresponding decrease in economic output, then the prices of all goods tend to fall. Periods of deflation most commonly occur after long periods of artificial monetary expansion. The early 1930s was the last time significant deflation was experienced in the United States. The major contributor to this deflationary period was the fall in the money supply following catastrophic bank failures. Other nations, such as Japan in the 1990s, have experienced deflation in modern times.

World-renowned economist Milton Friedman argued that under optimal policy, in which the central bank seeks a rate of deflation equal to the real interest rate on government bonds, the nominal rate should be zero, and the price level should fall steadily at the real rate of interest. His theory birthed the Friedman rule, a monetary policy rule.

However, declining prices can be caused by a number of other factors: a decline in aggregate demand (a decrease in the total demand for goods and services) and increased productivity. A decline in aggregate demand typically results in subsequent lower prices. Causes of this shift include reduced government spending, stock market failure, consumer desire to increase savings, and tightening monetary policies (higher interest rates). 

Falling prices can also happen naturally when the output of the economy grows faster than the supply of circulating money and credit. This occurs especially when technology advances the productivity of an economy, and is often concentrated in goods and industries which benefit from technological improvements. Companies operate more efficiently as technology advances. These operational improvements lead to lower production costs and cost savings transferred to consumers in the form of lower prices. This is distinct from but similar to general price deflation, which is a general decrease in the price level and increase in the purchasing power of money. 

Price deflation through increased productivity is different in specific industries. For example, consider how increased productivity affects the technology sector. In the last few decades, improvements in technology have resulted in significant reductions in the average cost per gigabyte of data. In 1980, the average cost of one gigabyte of data was $437,500; by 2010, the average cost was three cents. This reduction caused the prices of manufactured products that use this technology to also fall significantly.

Consequences of Deflation

While it may seem like lower prices are good, deflation can ripple through the economy, such as when it causes high unemployment, and can turn a bad situation, such as a recession, into a worse situation, such as a depression.

Deflation can lead to unemployment because when companies make less money, they react by cutting costs in order to survive. This includes closing stores, plants, and warehouses and laying off workers. These workers then have to decrease their own spending, which leads to even less demand and more deflation and causes a deflationary spiral that is hard to break. The only time deflation can work without hurting the rest of the economy is when businesses are able to cut the costs of production in order to lower prices, such as with technology. The cost of technology products has decreased over the years, but it is because the cost of producing that technology has decreased, not because of decreased demand. 

A deflationary spiral can occur during periods of economic crisis, such as a recession or depression, as economic output slows and demand for investment and consumption dries up. This may lead to an overall decline in asset prices as producers are forced to liquidate inventories that people no longer want to buy. Consumers and businesses alike begin holding on to liquid money reserves to cushion against further financial loss. As more money is saved, less money is spent, further decreasing aggregate demand. At this point, people's expectations regarding future inflation are also lowered and they begin to hoard money. Consumers have less incentive to spend money today when they can reasonably expect that their money will have more purchasing power tomorrow.

(For related reading, see: Why Is Deflation Bad for the Economy?)