Deflation is a decrease in the general price level of goods and services. Put another way, deflation is negative inflation. When it occurs, the value of currency grows over time. Thus, more goods and services can be purchased for the same amount of money.
Deflation is widely regarded as an economic “problem” that can intensify a recession or lead to a deflationary spiral.
Causes of Deflation
Economists determine the two major causes of deflation in an economy as (1) fall in aggregate demand and (2) increase in aggregate supply.
The fall in aggregate demand triggers a decline in the prices of goods and services. Some factors leading to a decline in aggregate demand are:
Fall in the money supply
A central bank may use a tighter monetary policy by increasing interest rates. Thus, people, instead of spending their money immediately, prefer to save more of it. In addition, increasing interest rates lead to higher borrowing costs, which also discourages spending in the economy.
Decline in confidence
Negative events in the economy, such as recession, may also cause a fall in aggregate demand. For example, during a recession, people can become more pessimistic about the future of the economy. Subsequently, they prefer to increase their savings and reduce current spending.
An increase in aggregate supply is another trigger for deflation. Subsequently, producers will face fiercer competition and be forced to lower prices. The growth in aggregate supply can be caused by the following factors:
Lower production costs
A decline in price for key production inputs (e.g., oil) will lower production costs. Producers will be able to increase production output, which will lead to an oversupply in the economy. If demand remains unchanged, producers will need to lower their prices on goods to keep people buying them.
Advances in technology or rapid application of new technologies in production can cause an increase in aggregate supply. Technological advances will allow producers to lower costs. Thus, the prices of products will likely go down.
Effects of Deflation
Frequently, deflation occurs during recessions. It is considered an adverse economic event and can cause many negative effects on the economy, including:
Increase in unemployment
During deflation, the unemployment rate will rise. Since price levels are decreasing, producers tend to cut their costs by laying off their employees.
Increase in the real value of debt
Deflation is associated with an increase in interest rates, which will cause an increase in the real value of debt. As a result, consumers are likely to defer their spending.
This is a situation where decreasing price levels trigger a chain reaction that leads to lower production, lower wages, decreased demand, and even lower price levels. During a recession, the deflation spiral is a significant economic challenge because it further worsens the economic situation.
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