What is Deflation?
Deflation occurs when an economy’s aggregate measure of pricing, i.e. the consumer price index (CPI), experiences a sustained, long-term decline.
A period of deflation consists of a long-lasting decline in prices that affects the entire economy.
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How Does Deflation Work in Economics?
An economy in a state of deflation is characterized by the price of its goods and services declining over an extended period of time.
In the beginning, consumers can benefit from increased purchasing power, meaning that more goods can be bought using the same amount of money.
While the initial price decrease might be viewed positively by certain consumers, the negative effects of deflation gradually become more pronounced over time.
Deflation can go hand-in-hand with an impending economic downturn, often signaling that a long-lasting recession might be on the horizon.
While prices decline, the spending behavior of consumers tends to change, wherein purchases are intentionally delayed in anticipation of steeper discounts, i.e. consumers begin to hoard cash.
The slowdown in consumer spending frequently accelerates a transition to an economic downturn because companies selling products generate less revenue.
In addition, the interest rate environment can affect the severity of the effects of deflation on the broader economy.
Deflation is caused by the following two factors:
- Excess Aggregate Supply
- Reduced Aggregate Demand (and Less Consumer Spending)
What Causes Deflation?
Deflationary periods are often attributed to a long-term contraction in the supply of money circulating in the economy.
The economic contraction indicative of deflation can be triggered by reduced spending from consumers, which can result from consumers waiting for prices to continue to decline.
Some adverse long-term effects of deflation include:
- Reduced Aggregate Demand (Less Consumer Spending)
- Higher Interest Rates and Contraction in Credit Markets
- Increased Unemployment Rates and Lower Wages
- Less Profitable Companies
- Long-Term Slowdown in Economic Production Output
- Negative Feedback Loop Triggered by the Lower Consumer Spending
- Portfolio Values Decline
- Increased Number of Defaults and Bankruptcies
While the economic output may remain the same in the early stages of deflation, eventually, the decrease in total revenue negatively affects a country’s employment statistics (i.e. higher unemployment) and more bankruptcies, among other consequences.
The credit markets also contract as the demand for credit from consumers and companies exceeds the supply, i.e. credit becomes limited with unfavorable financing terms as lenders are weary of the growing default risk of borrowers and are bracing for an impending recession.
Another factor contributing to deflationary risk is increased productivity and efficiency (e.g. the integration of software/tech in traditional industries), which maintains the total level of economic output in line with or above historical levels despite requiring less labor.
Short periods of declining prices can be positive for an economy with minimal long-term damage.
The issue that tends to lead to an economic shock is the credit environment of the economy, i.e. the amount of debt utilized by consumers and companies.
Suppose a country’s producers possess excess supply, where the number of products on hand to sell to consumers exceeds the demand from consumers.
In the scenario above, the companies that produce the goods and sell them have no choice but to undergo operational restructuring to remain profitable or cut their prices to sell more goods.
