What is a Deflationary Spiral
A deflationary spiral is a downward price reaction to an economic crisis leading to lower production, lower wages, decreased demand and still lower prices. Deflation occurs when general price levels decline, as opposed to inflation which is when general price levels rise. When deflation occurs, central banks and monetary authorities can enact expansionary monetary policies to spur demand and economic growth. If monetary policy efforts fail, however, due to greater-than-anticipated weakness in the economy or because target interest rates are already zero or close to zero, a deflationary spiral may occur even with an expansionary monetary policy in place. Such a spiral amounts to a vicious circle, where a chain of events reinforces an initial problem.
BREAKING DOWN Deflationary Spiral
A deflationary spiral typically occurs 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.
Deflationary Spiral and Recession
In a recession, demand decreases and companies produce less. Low demand for a given supply equals low prices. As production cuts back to accommodate the lower demand, companies reduce their workforce resulting in an increase in unemployment. These unemployed individuals may have a hard time finding new work during a recession and will eventually deplete their savings in order to make ends meet, eventually defaulting on various debt obligations such as mortgages, car loans, student loans and on credit cards. The accumulating bad debts ripple through the economy up to the financial sector, which must then write them off as losses. Financial institutions begin to collapse, removing much needed liquidity from the system and also reducing the supply of credit to those seeking new loans.
Deflationary Spiral: How to React
It was believed that deflation would eventually cure itself, as economists reasoned that low prices would spur demand. Later, during the Great Depression, economists challenged that assumption and argued that central banks needed to intervene to ramp up demand with tax cuts or more government spending. Using monetary policy to spur demand has some pitfalls, however. For example, low interest rate policies used in Japan and the United States in the 1990s–2000s, which sought to alleviate stock market shocks, showed that a frequent result is abnormally high asset prices and too much debt being held, which can lead to deflation and a deflationary spiral itself.