A:

Before we delve right into the topic of deflation, it should be noted that the causes and effects of deflation are complex economic forces. In this answer, we'll simply introduce readers to the concept and explain how it affects investors.

Deflation is a macroeconomic condition where a country experiences lowering prices. This is the opposite of inflation which is characterized by rising prices (do not confuse deflation with disinflation, which is simply a slowing of inflation). To many economists, deflation is more serious than inflation because deflation is more difficult to control. Let's take a look at the different effects of deflation.

One would think that people would be happier if prices were to go down. Everything becomes cheaper, and the money that we have seems to go a little further than it used to. However, when this effect drags on for too long, companies' profits begin to decline. Economic conditions (i.e. excess supply) force companies to sell their products for even cheaper and subsequently cut back on production costs, reduce employee wages, lay off workers or even close production facilities. At this point, unemployment will increase, the economy cannot expand and people aren't spending their money because their economic future seems uncertain.

Equity prices begin to decline as people sell off their investments, which are no longer offering good returns, and bonds temporarily become more attractive. Until the government can find a way to increase consumer and business spending - usually by lowering interest rates to stimulate the economy - equity prices will take a severe beating.

Now that you know the effects of deflation, you can imagine why it is considered worse than inflation: in times of inflation, governments curb spending and encourage saving by increasing interest rates, but as governments will do the opposite to encourage spending during deflation, they cannot lower the nominal interest rates to a negative level, or below zero. Central banks in areas affected by deflation can only move the rate by a certain amount.

If you would like to learn more about deflation, a great place to start is our Inflation Tutorial.

RELATED FAQS
  1. What can cause price deflation?

    Learn what price deflation is, how inflation rates can be calculated using the consumer price index and what some causes ... Read Answer >>
  2. What is the difference between inflation and deflation?

    Determine how inflation and deflation affect prices and employment. Economies frequently teeter between these two economic ... Read Answer >>
  3. How does deflation impact consumers?

    Learn about how deflation affects consumers; they thrive in the short term, but in the long term, deflation can be disastrous ... Read Answer >>
  4. 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 dropping prices ... Read Answer >>
  5. What's the lowest year-over-year inflation rate in the history of the U.S.?

    Learn about years with the lowest year-over-inflation in U.S. history. Read about how inflation is calculated using the consumer ... Read Answer >>
Related Articles
  1. Insights

    What's The Difference Between Inflation And Deflation?

    Inflation occurs when the prices of goods and services rise. Deflation occurs when prices decrease.
  2. Insights

    Why is Deflation Bad for the Economy?

    Deflation can adversely affect the economy in significant ways.
  3. Insights

    Why Deflation Is The Fed's Worst Nightmare

    The measures taken by central banks seem to be winning the battle against deflation, but it is too early to tell if they have won the war.
  4. Investing

    Protect Your Portfolio Against Inflation And Deflation

    Inflation and deflation are opposite sides of the same coin. When both are threatening, here's what to do to keep your portfolio safe.
  5. Insights

    Do Deflationary Shocks Help Or Hurt The Economy?

    Find out how deflationary shocks can both benefit and hurt consumers and businesses.
  6. Insights

    The Dangers Of Deflation

    We look at what life would be like in a deflationary environment, and what you can do to protect your investments.
  7. 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.
  8. Insights

    The Top 6 Ways Governments Fight Deflation

    Here are six monetary and fiscal policy tools that governments use to fight deflation.
  9. Insights

    Should You Worry About the U.S Inflation rate?

    Understand how inflation is measured, how U.S. inflation compares to other countries, and if investors should be concerned with rising inflation.
  10. Financial Advisor

    Oil or Gold: Which Will Recover First? (USO)

    Not sure where oil and gold are headed? The answer is complex.
RELATED TERMS
  1. Debt Deflation

    A situation in which the collateral used to secure a loan (or ...
  2. GDP Price Deflator

    An economic metric that accounts for inflation by converting ...
  3. Pigou Effect

    A term in economics referring to the relationship between consumption, ...
  4. Central Bank

    The entity responsible for overseeing the monetary system for ...
  5. Inflation Protected

    The types of investments that provide protection against inflation ...
  6. Supply Chain

    A supply chain is a network of entities and people that work ...
Hot Definitions
  1. Earnings Per Share - EPS

    Earnings per share (EPS) is the portion of a company's profit allocated to each outstanding share of common stock.
  2. Trustee

    A person or firm that holds or administers property or assets for the benefit of a third party. A trustee may be appointed ...
  3. Gross Domestic Product - GDP

    GDP is the monetary value of all the finished goods and services produced within a country's borders in a specific time period, ...
  4. Debt/Equity Ratio

    The D/E ratio indicates how much debt a company is using to finance its assets relative to the value of shareholders’ equity.
  5. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange.
  6. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows ...
Trading Center