Deflation occurs when the prices of goods and services decrease, i.e. when inflation goes below zero or into negative figures. Deflation should not be confused with disinflation, which refers to a slowing down in inflation (prices rising more slowly).
Deflation is the opposite of inflation (the increase in prices of goods and services). Both these terms describe the real value of money over time.
With inflation the value of money declines. The opposite is the case with deflation, when the value of money rises.
When an economy experiences deflation consumers are able to buy more goods and services per unit of currency. Whilst this may sound like a good thing for consumers, in the long run this can raise the real value of debt. Deflation, if it persists, can be very bad for an economy.
If inflation is too high the economy can overheat. With deflation unemployment can rise and the economy might shrink. Central banks in North America, Europe and Japan are all aiming for an inflation rate of about 2% per year.
What causes deflation?
Several factors, sometimes all occurring at the same time, can cause deflation. The main driver of deflation is a drop in demand for goods and services.
While growing demand fuels inflation, falling demand can trigger deflation.
If a country’s currency rises compared to other major currencies, especially that nation’s main trading partners, the price of imported goods will be cheaper.
What are the effects of deflation?
When prices start to drop several things begin to happen that are bad for the economy.
If you expect prices to continue falling you more likely to delay your purchases, because you may prefer to wait for cheaper prices later on. As more and more people do this, shops, manufacturers and service providers will sell less.
If businesses sell less everybody suffers – the whole economy slows down. Deflation can trigger a vicious cycle of declining demand, shrinking business activity, and job cuts.
Debt burden may rise with deflation
People with debts will eventually be worse off in a deflationary environment. Imagine your mortgage payments cost you $500 per month and your net income (after tax) is $4000 per month. Your mortgage payments represent 10% of your net income.
If deflation has slowed down the economy, companies may start reducing workers’ wages. If your net income drops to $3,500 per month, your mortgage payments will be higher than 10% (it will be 11.43% of your net income). Your debt burden has increased.
During a long period of inflation personal debts gradually get smaller – the opposite occurs during a long period of deflation.
In an interview with Diego Pizano in 1979, nobel laureate Friedrich Hayek, an Austrian Economist, said the following about deflation concerning the Great Depression:
I agree with Milton Friedman that once the Crash had occurred, the Federal Reserve System pursued a silly deflationary policy. I am not only against inflation but I am also against deflation. So, once again, a badly programmed monetary policy prolonged the depression.
Austrian economists believe the market should find its own way without any government intervention.
During periods of deflation, employers are less able to negotiate lower wage hikes (in real terms) when compared to periods of higher inflation. This is because of money illusion – where workers focus on the nominal value of a unit of currency and perceive, for example, a 0.5% wage increase when inflation is at 0% is a worse deal then a 7% pay increase when inflation is at 7%.
The Pigou Effect is an economics concept that suggests that deflation increases consumers’ purchasing power, which in turn means their expenditure rises, resulting on greater demand. Greater demand means that companies take on more workers – so employment rises. Several deflationary recessions over the past fifty years, particularly Japan’s ‘Lost Decade’, revealed some serious flaws in the arguments behind the Pigou Effect.
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