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What is 'Deflation'

Deflation is a contraction in the supply of circulated money within an economy, and therefore the opposite of inflation. In times of deflation, the purchasing power of currency and wages are higher than they otherwise would have been. This is distinct from but similar to price deflation, which is a general decrease in the price level, though the two terms are often mistaken for each other and used interchangeably.

BREAKING DOWN 'Deflation'

In effect, deflation causes the nominal costs of capital, labor, goods and services to be lower than if the money supply did not shrink. While price deflation is often a side effect of monetary deflation, this is not always the case.

Causes of Deflation

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. Periods of deflation most commonly occur after long periods of artificial monetary expansion.

There are two principle causes of price deflation. The first is a general increase in the demand for cash savings by consumers and businesses. This could be because consumers are uncertain, or because their time preferences for consumption have lengthened. The second cause is a general increase in economic productivity, which grows the supply of goods and boosts the purchasing power of incomes.

Price deflation through increased productivity is different in specific industries. Consider the technology sector, for example. In 1980, the average cost per gigabyte of data was $437,500; by 2010, the average gigabyte cost 3 cents. The decline of the price of advanced technology greatly increasing the standard of living around the world.

Changing Views On Deflation’s Impact

Following the Great Depression, when monetary deflation coincided with high unemployment and rising defaults, most economists believed deflation was per se an adverse phenomenon. Thereafter, most central banks adjusted monetary policy to promote consistent increases in the money supply, even if it promoted chronic price inflation and encouraged debtors to borrow too much.

In recent times, economists increasingly challenge the old interpretations about deflation, especially after the 2004 study by economists Andrew Atkeson and Patrick Kehoe, "Deflation and Depression: Is There an Empirical Link?" After reviewing 17 countries across 180 years, Atkeson and Kehoe found 65 out of 73 deflation episodes with no economic downturn, while 21 out of 29 depressions had no deflation. There are now a wide range of opinions on the usefulness of deflation and price deflation.

Deflation Changes Debt and Equity Financing

Deflation makes it less economical for governments, businesses and consumers to use debt financing. However, deflation increases the economic power of savings-based equity financing.

From an investor's point of view, companies that accumulate large cash reserves or that have relatively little debt are more attractive under deflation. The opposite is true of highly indebted businesses with little cash holdings. Deflation also encourages rising yields and increases the necessary risk premium on securities.

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