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Deflation is a general decline in prices for goods and services, typically
associated with a contraction in the supply of money and credit in the
economy. During deflation, the purchasing power of currency rises over
time.
Understanding Deflation
Deflation causes the nominal costs of capital, labor, goods, and services to
fall, though their relative prices may be unchanged. Deflation has been a
popular concern among economists for decades. On its face, deflation
benefits consumers because they can purchase more goods and services
with the same nominal income over time.
However, not everyone wins from lower prices and economists are often
concerned about the consequences of falling prices on various sectors of
the economy, especially in financial matters. In particular, deflation can
harm borrowers, who can be bound to pay their debts in money that is
worth more than the money they borrowed, as well as any financial market
participants who invest or speculate on the prospect of rising prices.
Deflation is the general decline of the price level of goods and
services.
Deflation is usually associated with a contraction in the supply of
money and credit, but prices can also fall due to increased
productivity and technological improvements.
Whether the economy, price level, and money supply are deflating
or inflating changes the appeal of different investment options.
Causes of Deflation
By definition, monetary deflation can only be caused by a decrease in the
supply of money or financial instruments redeemable in money. In modern
times, the money supply is most influenced by central banks, such as the
Federal Reserve. When the supply of money and credit falls, without a
corresponding decrease in economic output, then the prices of all goods
tend to fall. Periods of deflation most commonly occur after long periods of
artificial monetary expansion. The early 1930s was the last time significant
deflation was experienced in the United States. The major contributor to
this deflationary period was the fall in the money supply following
catastrophic bank failures. Other nations, such as Japan in the 1990s,
have experienced deflation in modern times.
Falling prices can also happen naturally when the output of the economy
grows faster than the supply of circulating money and credit. This occurs
especially when technology advances the productivity of an economy, and
is often concentrated in goods and industries which benefit from
technological improvements. Companies operate more efficiently as
technology advances. These operational improvements lead to lower
production costs and cost savings transferred to consumers in the form of
lower prices. This is distinct from but similar to general price deflation,
which is a general decrease in the price level and increase in the
purchasing power of money.
