Deflation - Explained
What is Deflation?
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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.
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.