What is Deflation?

In economics, deflation is a sustained decrease in the prices of goods and services and a contraction in the supply of circulated money within an economy. It is the opposite of inflation – in fact, deflation only occurs when inflation reaches a negative rate: below 0%.

Deflation should not be confused with disinflation, which means falling inflation, like a fall in consumer prices from 3% to 2%. In a disinflationary environment, inflation still remains positive.

During a deflationary period, the value of currency rises and gains buying power. This is reflected in the falling prices of goods and services. Consumers begin to think that the trend of falling prices will continue, and will delay their purchases in the hope getting a better bargain. This withholding of spending only makes the problem worse. Reduced spending drives down corporate profits, which in turn results in cost cutting and unemployment,  also worsening the deflation.

Modern day economists generally believe that deflation is a problem because it increases the real value of debt and that prolonged deflation scenarios may start a deflationary spiral as outlined above. Nevertheless, sectors like technology have experienced a price deflation over the last three decades, greatly increasing the standard of living around the world.

Deflation can be triggered either by a general increase in the demand for cash by consumers or by a general increase in economic productivity, which increases the supply of goods and boosts the purchasing power of consumers.

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Category: Financial Glossary

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