What is Deflation?

Deflation is an economic condition where the price of goods, services, and labor declines because of the increase in the purchasing power of the nation's currency. The increase in the purchasing power of the currency is generally related to limitations in the money supply due to economic stagnation or limited available credit. For this reason, the nominal purchase price of goods may decline, while the relative purchase price remains the same.

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How Does Deflation Work?

Most countries have a central banking institution that controls the nations money supply through its monetary policy. These policies change with the purpose of creating economic stability by promoting growth and combating excessive inflation or deflation. The major causes of deflation are highlighted below:

• A decrease in the supply of money: Decline in money supply can result from the monetary policy used by the central bank or from other causes. A shortage of money supply can also be linked to decisions made by the central bank. For instance, when the central bank increases interest rates paid on loans by consumers, it can lead to a fall in the money supply.
• A decline in production costs: When there are lower costs of production in an economy, it translates to increased productivity which, in turn, causes deflation. Generally, increased productivity leads to a decrease in the price of goods and services.
• Advancement in technologies: When companies begin to improve their production and have more productions using new technologies, it leads to an aggregate increase in supply and thereafter a decline in the prices of goods and services.
• A decline in aggregate demand: When an increase in aggregate supply is met by a decrease in aggregate demand, deflation will occur.

While not all deflation results in economic downturns, the major historical impacts of deflation are:

• An increase in the unemployment rate,
• A rise in the rate of defaults, and
• An increase in the real value of debt

Incidental effects of deflation include increased equity financing as opposed to debt financing in companies.

Related Topics

• Inflation
• Core Inflation
• Cost Push Inflation
• Demand Pull Inflation
• Wage Push Inflation
• Inflation Spiral (Wage-Price Spiral)
• Agflation
• Basket of Goods and Services
• Indexing and Index Number
• Base Year
• Consumer Price Index
• Substitution Bias
• Quality / New Goods Bias
• Core Inflation Index
• Producer Price Index
• International Price Index
• Employment Cost Index
• Buying Power Index
• Breakfast Index
• Employment Cost Index
• Producer Price Index
• Capital Goods Price Index
• Farm (Agricultural) Price Index
• Harmonized Index of Consumer Prices
• Repeated Sales Method (Real Estate)
• GDP Deflator
• Deflation
• Pigou Effect
• Hyperinflation (Economics)
• Biflation
• Inflation and Redistribution of Purchasing Power
• Inflation Blurs Price Signals
• Inflation Affects Long-Term Planning
• What are the Benefits of Inflation?
• Indexing and Index Number
• Cost of Living Allowance
• Adjustable Rate Mortgage