Deflation is a contraction of the money supply in an economy, which can cause a general decline in prices in an economy. That is, the opposite of inflation.

The decrease in prices occurs as a result of the reduction of the money supply, which increases the value of the currency, thus increasing its purchasing power. With the same amount of money we can buy more things. When there is price deflation, the goods and services available in an economy go down in price. In other words, products get cheaper.

In economic theory, deflation is the reduction of the money supply. Its immediate effect is usually price deflation. For this reason, the concept of deflation is often used colloquially to refer to the general decline in the prices of goods and services. Since our goal is to simplify the economy, we are going to call the general decline in prices deflation.

Causes of deflation

Deflation has only two possible causes:

  • Reduced demand: When demand is reduced in a given economy, prices tend to fall, generating deflation.
  • Excess supply: On the contrary, when there is an increase in supply that the market is not able to absorb, there is a reduction in prices.

Consequences of deflation

Among the different effects of deflation, we highlight the most important:

  • Disincentives consumption: The consumer considers that it is better to wait than to buy, since prices fall.
  • Savings increase: It is caused because the money saved will have greater value in the future than in the present.
  • The real value of the debt increases: When the value of money increases, the real value of the debt increases.
  • Unemployment increases: This is due to a reduction in business income.

Deflation and the law of supply and demand

Price deflation not only arises from the contraction of the money supply, but can also occur when the supply of goods and services in an economy is greater than the demand. Therefore, in order to sell all their products, entrepreneurs are forced to lower prices.

This can be caused by a decrease in demand as a result of a contraction in the economy. Caused, for example, by fear of an economic recession that reduces the demand for goods and services, which is negative for the economy.

But it can also occur as a result of an increase in production, which causes the available quantity of goods and services to increase faster than the money supply, leading to an excess of money supply. In this case, deflation is good for the economy. In short, deflation evolves (among other factors) according to the law of supply and demand.

Advantages of deflation

By lowering the prices of goods and services, if wages are maintained, the amount of things that can be bought with the same wage will increase, that is, purchasing power will increase. When this happens, employers decide to invest more in capital goods and less in workers, producing a shift from employment to more productive jobs with higher added value.

In addition, deflation encourages savings, which causes prices to continue to fall and less is consumed. That saving will also make there more money to lend (more money supply), which will cause interest rates to fall.

Deflation compensates for misalignments in business cycles and excessively high price rises. As a consequence of the expansionary cycle of an economy, on many occasions there are exaggerated increases in prices, which favored sellers. Therefore, a price deflation will be an adjustment that brings prices to equilibrium, thus favoring buyers.

Disadvantages of deflation

At first glance we might think that it is good, that for our pocket it would be better, since with the same amount of money we could buy a greater amount of goods. However, deflation creates a vicious spiral of falling prices, wages and production, which in many cases hurts economies, and can create or exacerbate recessions.

Deflation can be dangerous, because it generates a vicious cycle of lower prices and this causes the economy's consumption to stagnate. Companies reduce production because there is less consumption and therefore they are forced to lay off workers. Which in turn produces less consumption and again an excess supply, which causes prices to drop. This is what is known as a deflationary spiral.

Deflation is a problem of expectations of future prices. If a central bank announces that prices are going to fall, the agents acting in it would decide to postpone their purchases until said price drop was real, since they would think, why buy today if it will be cheaper tomorrow?

For this reason, central banks around the world are targeting price stability, seeking inflation around 2% (it differs according to central banks, but never gets too close to 0).

Excessive inflation is bad, but it is even more dangerous to fall into deflation, hence the effort on the part of central banks to always obtain low but positive inflation. Mainly because deflation is one of the greatest fears of any economic manager in a country, because it causes long-term economic crises.

Deflation example

The clearest example of deflation is Japan. Between 2008 and 2013, prices decreased steadily.

Although it is a phenomenon with many causes, the main factor was the culture of Japanese society. Japan is a country with a very aging, conservative population and with a very important savings mentality.

In other words, deflation occurred due to a lack of demand.

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