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What is Deflation?

deflation Lengthy periods of deflation are bad for the economy. / Credit: Lightspring | Shutterstock.com

While inflation may be talked about regularly in this country, rarely does the discussion turn to deflation.  That leaves many wondering what deflation actually is and whether it is good or bad for the economy.

What is Deflation?

Deflation is when the prices of good and services fall; giving consumers more purchasing power because the money they have can now buy more than it previously could. Deflation is the opposite of inflation, which is the rate at which the cost of goods and services rise over time. When inflation rises, the value of the dollar goes down because consumers aren't able to buy as much as they previously could.

Similarly to how inflation is calculated, deflation is measured by the Consumer Price Index. Deflation technically occurs when inflation rates dip below 0 percent. When inflation rates are dropping but still are above zero, disinflation – not deflation – is occurring.

Deflation is caused by several factors, including a fall in consumer demand. When shoppers aren't spending as much as they were in the past, prices start to fall to encourage more spending. A drop in consumer spending can be attributed to a variety of issues, including a decrease in the amount of disposable income and consumers' confidence their financial future. Deflation can also be caused by a decrease in the money supply or an increase in the supply of goods. Combinations of various monetary policies and fiscal policies are implemented to combat deflation. Steps include reducing interest rates and decreasing taxes – both of which can help stimulate spending, which in turn will increase the demand of goods and services and eventually can lead to a rise in prices and the end of deflation.

The effects of deflation

While a drop in prices might seem like a good thing, lengthy periods of deflation are in most cases bad for an economy. One of the largest impacts on the economy of a deflationary period is decreased business revenues. Since prices are forced down, the amount of money each business makes also takes a dive. The drop in revenue then leads to salary cuts and job losses. A reduction in wages, as well as a rise in unemployment, leads to a change in customer spending. In addition, deflation results in a drop in equity prices as consumers being to sell off their investments. Since deflation is so difficult to control, it is considered by many to be worse than inflation. At its worst, deflation can turn into a deflationary spiral that can eventually lead to the collapse of a country's currency.

History of deflation

Deflation in the United States is very rare, and hasn't occurred in more than six decades. While there have been brief periods of deflation in the past 100 years, the country hasn't experienced a prolonged period of deflation since the Great Depression in the 1920s. The period was marred by a massive drop in prices that put many companies out of business and their employees out of work.

Most recently, Japan's economy has been plagued by deflation. The period of deflation lasted more than 15 years, caused by a combination of factors including an increase in taxes, heavy government spending and tight monetary policies.

Follow Chad Brooks on Twitter @cbrooks76 or BusinessNewsDaily @BNDarticles. We're also on Facebook & Google+.

Chad Brooks

Chad Brooks is a Chicago-based writer who has nearly 15 years' experience in the media business. A graduate of Indiana University, he spent nearly a decade as a staff reporter for the Daily Herald in suburban Chicago, covering a wide array of topics including, local and state government, crime, the legal system and education. Following his years at the newspaper Chad worked in public relations, helping promote small businesses throughout the U.S. Follow him on Twitter.