Deflation

Deflation is a decrease in the general price level of goods and services in an economy. It occurs when the inflation rate falls below zero percent, resulting in a negative inflation rate. When the general price level falls, each unit of currency buys more goods and services than before; consequently, deflation corresponds to an increase in the purchasing power of money. Deflation is the opposite of inflation and is distinct from disinflation, which is a slowdown in the rate of inflation (prices still rise, but more slowly).

In a modern economy, economists generally regard a sudden deflationary shock as a serious problem, because it increases the real value of debt, particularly when the deflation is unexpected. Deflation may aggravate recessions and, in severe cases, lead to a self-reinforcing deflationary spiral.

Definition

Deflation is defined as a generalised and sustained decline in prices that is broad-based across most, if not all, goods and services in an economy. A decline in the price of a single good or in one sector does not constitute deflation. Sector-specific price declines may occur because productivity is rising faster in that sector or because demand for that sector's output is weak; such changes are generally not a problem for the economy as a whole and do not amount to deflation.

Deflation per se occurs only when price declines are widespread enough that broad-based indexes of prices, such as the consumer price index, register ongoing declines.

Comparison with related concepts

Deflation is frequently confused with disinflation. The distinction is important:

Concept	Description
Inflation	A sustained increase in the general price level; the inflation rate is positive.
Disinflation	A slowdown in the rate of inflation; prices still rise, but more slowly than before.
Deflation	A sustained decrease in the general price level; the inflation rate is negative.
Hyperinflation	An extremely rapid and out-of-control increase in the price level.

Causes

Deflation arises from an imbalance between the supply of and demand for goods, on the one hand, and the supply of and demand for money, on the other. Its causes are commonly grouped into several categories.

Demand-side causes

Deflation can be caused by weakness on the demand side of the economy. When demand slackens, producers reduce prices in order to retain customers; if such price-cutting becomes widespread, deflation results. In almost all cases, deflation is a side effect of a collapse of aggregate demand—a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers.

Supply-side and productivity causes (growth deflation)

Deflation may also occur when the supply of goods rises faster than the supply of money. Improvements in production efficiency lower the overall cost of goods, and competition prompts producers to pass at least part of these savings on to consumers through lower prices. This so-called growth deflation is generally considered benign, since purchasing power increases without a decline in output.

Money supply-side causes

From a monetarist perspective, deflation is caused primarily by a reduction in the velocity of money or in the amount of money supply per person. As the economist Milton Friedman observed, "Inflation is always and everywhere a monetary phenomenon"; persistent deflation is likewise, in the long run, a monetary phenomenon. If monetary growth lags behind the growth in purchases of goods and services, deflation follows, as fewer units of currency chase more products and prices must decline.

Credit deflation

In modern credit-based economies, deflation may be triggered when a central bank raises interest rates to control inflation, thereby deflating an asset bubble. A slowdown or fall in lending leads to less money in circulation, with a further sharp fall in the money supply as confidence erodes and velocity weakens, followed by a sharp decline in demand and employment. The fall in demand causes prices to fall as a supply glut develops.

Debt deflation

Debt deflation is a phenomenon associated with the end of long-term credit cycles. It was proposed as a theory by the economist Irving Fisher (1933) to explain the deflation of the Great Depression. In Fisher's account, debt liquidation leads to distress selling and a contraction of bank deposits, causing a fall in the price level and corporate profits, a contraction in output, trade, and employment, and ultimately bankruptcies. The resulting loss of confidence leads to the hoarding of money, which pushes up real interest rates and sparks another round of debt liquidation.

The deflationary spiral

When prices are falling, consumers have an incentive to delay purchases in the expectation that prices will fall further. When purchases are delayed, productive capacity is idled and investment falls, leading to further reductions in aggregate demand. This self-reinforcing process is known as the deflationary spiral. Deflation is also related to risk aversion, in which investors and buyers begin hoarding money because its value is increasing over time; this can produce a liquidity trap.

To reverse a deflationary spiral quickly, an economic stimulus may be introduced: a government can increase productive spending on items such as infrastructure, or a central bank can expand the money supply.

Effects

Deflation is widely considered harmful to a modern economy for several reasons:

• Rising real debt burden — because the value of money rises over time, debts become increasingly expensive to repay in real terms. This may cause bankruptcies and disrupt the financial system as lenders are left with non-performing loans. Households and firms that accumulated substantial debt before deflation began bear the greatest burden.
• Deferred spending — if consumers anticipate that goods will cost less in the future, they have an incentive to postpone purchases, weakening overall demand and slowing the economy.
• The zero lower bound — when inflation falls to zero or deflation sets in, nominal interest rates fall toward zero. Once the nominal interest rate reaches zero, no further downward adjustment is possible, since lenders will generally not accept a negative nominal rate when cash can be held instead. This limits the ability of conventional monetary policy to stimulate the economy.
• Recession and financial stress — a deflationary recession may differ from an ordinary recession in that deflation of sufficient magnitude can push nominal interest rates to zero, and the real cost of borrowing can become prohibitive, worsening the downturn.

In less severe downturns, price inflation typically also falls or turns negative for short periods as prices adjust to the fall in aggregate demand, which can buffer the adverse impact of a sharp fall in GDP and aid recovery.

Historical episodes

Deflation has occurred periodically throughout economic history, most notably under the gold standard, when the money supply was constrained by national gold reserves. When gold reserves and money grew more slowly than production, prices would fall. During the accelerated-productivity era of 1870–1900, rising productivity and reduced transportation costs produced structural deflation. Most nations abandoned the gold standard in the 1930s, reducing the likelihood of deflation under a fiat monetary system, aside from the collapse of speculative asset classes.

The most significant modern episode was the Great Depression of the 1930s, when the United States price level fell by roughly 10 percent per year in the years 1930–33, and massive financial problems—including defaults, bankruptcies, and bank failures—were endemic. Studies by Ben Bernanke have indicated that, in response to decreased demand, the Federal Reserve of the time decreased the money supply, thereby contributing to the deflation.

Japan has been the most notable recent example of a prolonged period of weak demand, a troubled financial sector, and persistent deflation, which has been associated with what economists term "debt-deflation"—the deflation-induced, ever-increasing real value of debts.

Policy responses

Because deflation poses special problems for conventional monetary policy, central banks have developed additional tools to combat it. When the short-term nominal interest rate approaches zero, a central bank can no longer ease policy by lowering its usual interest-rate target. In such circumstances, it may resort to unconventional monetary policy, such as purchasing longer-term bonds to reduce longer-term interest rates—a strategy commonly described as quantitative easing.

Fiscal policy may also be used: a government can increase productive spending to stimulate aggregate demand. The credibility of a central bank in managing inflation expectations plays an important role in preventing deflation from becoming entrenched.

See also

• Inflation
• Disinflation
• Hyperinflation
• Debt deflation
• Liquidity trap
• Great Depression
• Monetary policy
• Recession