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What is Deflation?


The term 'Deflation' is included in the Economics edition of the Financial Dictionary. Get yours now on amazon in ebook or paperback format. Read more here...

Deflation is simply the prices of goods and services going down in a given time frame. Deflation is the opposite of inflation, which is the rising cost of goods and services over a period of time. This does not make deflation a good thing in the long run.

Another way of defining deflation is the increasing value of money versus various economic goods over a span of time. With inflation, money is becoming less valuable versus goods over time. Deflation happens as a result of the interaction of four factors. On the one hand, the supply of money in circulation might decline. At the same time, supplies of available goods might increase. The need for goods could drop as well. Finally, the demand for money could go up. If any of these four things happen either separately or in concert, deflation is commonly the result.

The easiest way for deflation to occur is as the supply of goods available on the market goes up at a more rapid pace than does the supply of money. The combination of these elements explains how some goods’ costs go up while the costs of others go down at the same time. Despite this, deflation can pose certain problems.

The majority of economists today concur that deflation proves to be both a symptom of economic problems as well as a malaise in and of itself. Some buy into the concepts of good and bad deflation. Good deflation happens as companies are consistently capable of manufacturing goods for cheaper and lower prices because of gains in productivity and other ways of reducing costs. This type of deflation permits a strong and growing GDP growth, with lower unemployment, and rising profits.

Bad deflation is more challenging to grasp. Bad deflation rises as a result of the central bank, or the Federal Reserve, choosing to revalue the country’s currency. Or, you could say that the supply of money declining results in this negative form of deflation.

The actual problem that deflation causes is that it creates uncertainty for businesses and their relationships. As a rule, business thrives on confidence and falters on the unknown. Borrowers have to make loan payments that turn out to be greater and greater amounts of purchasing power in deflationary time periods. All the while, the value of the asset that you purchased with the loan is declining. In these circumstances, many borrowers elect to default on the loan and its payments.

A declining spiral similarly exists in deflationary periods. Since businesses begin to enjoy fewer profits, they decide to reduce their employment roles. Individuals do not spend as much money as a result. Businesses then realize smaller profits and again cut back. This degenerates into a vicious cycle down before long, as it becomes self reinforcing. Consumers learn that larger ticket items such as houses and cars will actually cost less in the future and then delay their purchases.

Though deflation has been discussed as a potential problem for the U.S. economy with the economic downturn, the reality is far different. At the same time, from 2006 to 2009, the Federal Reserve massively increased the money supply by more than three hundred percent. This argues not for deflation in the United States’ future, but for inflation instead.

The term 'Deflation' is included in the Economics edition of the Financial Dictionary. You can get your copy on amazon in Kindle or Paperback version. See more details here.