A:

The cause and effect of deflation are complex economic forces, which requires a short introduction to the concept and an explanation of 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. (Note: Deflation is different from disinflation, which is 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.

Yes, people would presumably be happier if prices were to go down. Everything becomes cheaper, and the money that we have seems to go a little further than before. However, when this effect drags on for too long, companies' profits begin to decline. Economic conditions (such as 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 be negatively impacted.

Now that you know the effects of deflation, you can imagine why it is considered worse than inflation, because in times of inflation, governments curb spending and encourage saving by increasing interest rates. However, as governments 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.

For further reading, see "All About Inflation."

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