Deflation Explained: Causes and Examples of Deflation

Also known as a negative inflation rate in macroeconomics, deflation occurs when prices fall. Learn about the causes, effects, and history of deflation.

What Is Deflation?

Deflation is the decrease of asset prices or the prices of goods and services. Also known as a negative inflation rate, deflation occurs when prices fall. As prices deflate, purchasing power increases, meaning consumers can use the same amount of money to purchase a larger amount of goods or services. Deflation is distinct from disinflation, which refers to the slowing of an inflation rate.

3 Causes of Deflation

The causes of deflation are tied to supply and demand.

  1. Aggregate demand decrease: One of the main causes of deflation is a drop in demand within an economy. Lower economic activity is sometimes connected to a change in monetary policy such as higher interest rates or lower government spending.
  2. Aggregate supply increase: When there is an excess in the supply of goods, companies must lower prices to offset the surplus of materials.
  3. Decrease in the supply of money: Another cause for deflation is a decrease in the amount of money circulating in an economy.

5 Effects of Deflation on an Economy

Deflation can have several negative effects on an economy.

  1. High unemployment rates: Firms attempting to offset production costs and falling prices may lower wages and lay off employees.
  2. Slower economic activity: As more people lose their jobs during deflation, consumer spending drops and causes a slowdown in economic growth.
  3. Debt: Deflation causes an increase in the real value of debt. Deflating prices of real estate and other assets cause lenders to refrain from giving borrowers, or debtors, new loans. In an attempt to encourage more economic activity, central banks might lower interest rates.
  4. Stock market drop: During deflationary periods, stock markets often crash as investors pull out because of increased volatility and a lack of returns. Instead, investors depend on their cash reserves.
  5. Deflationary spiral: Periods of deflation can lead to more self-reinforcing economic downturns. This chain reaction can result in a catastrophic financial crisis.

How to Analyze Deflation

Economists use the Consumer Price Index (CPI) to analyze deflation. The CPI compares the general price level of certain consumer goods and services over a specific period of time. By comparing the differences in pricing over time, economists can identify price deflation in an economy.

3 Historic Deflations

To learn more about how deflation works in the real world, consider some of these historical examples.

  1. The recession of 1920–1921: Following World War I and the 1918 influenza pandemic, the US economy experienced deflation as the prices of goods and services dropped for over a year.
  2. The Great Depression: The Great Depression lasted from 1929 to 1939. During this period, the US Federal Reserve, or the Fed, raised interest rates in an attempt to counteract the crashing stock market. Unfortunately, this strategy failed and consumer spending dropped, continuing a deflationary spiral.
  3. The Lost Decades: In 1991, asset prices plummeted in Japan. As a result, the Japanese economy experienced persistent deflation for years.

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