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What Is Deflation?

image for ipopba / Getty Images
ipopba / Getty Images
  • Deflation is much less talked about than inflation, leaving many to wonder what deflation is.
  • Deflation is rare in the U.S.; it has not happened in over six decades. 
  • Deflation has two major causes: an increase in supply and a decrease in demand. 

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

Deflation is when the prices of goods and services fall. This gives 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 costs of goods and services rises over time. When inflation rises, the value of the dollar goes down because consumers cannot 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 drop but they are still above zero, disinflation – not deflation – occurs.

Deflation is caused by several factors, including a fall in consumer demand for goods and services. 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 in 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 to stimulate spending, which, in turn, increases the demand for goods and services and eventually can lead to a rise in prices and the end of deflation.

The causes of deflation go back to supply and demand. When the demand for goods and services goes down and the supply increases, it causes deflation. Another term that is often used for deflation is negative inflation. 

One cause of a decrease in demand for goods and services is an increase in interest rates. When consumers see interest rates rise, they are less likely to want to spend their money. They lean more toward saving than spending and, in turn, buy less. That means the demand goes down. When consumers are feeling negative about their financial future, they are also less likely to buy things, especially if these things are considered wants rather than needs. 

Some causes of increased supply are increased technology and lower production costs. When suppliers can produce an item at a lower cost, they tend to manufacture more of that item, resulting in a large supply. When consumers are buying less and there is an increase in supply, the prices of items must drop to encourage people to buy. Advances in technology help to increase production because items are easy and cheaper to make. This causes the supply to increase, which often drives the prices down so consumers will purchase more. 

When producers are forced to cut prices below the cost of an item, businesses lose money. The low prices resulting from deflation may be good for consumers, but if the prices drop too low, it is bad for producers. 

In the United States, the official calculation of deflation is done by the U.S. Department of Labor's Bureau of Statistics (BLS). The BLS surveys the prices of goods throughout the U.S. and compares the data it collects. If the price index is lower now than it was previously, it is considered deflation.

Here is the formula used to calculate the rate of deflation:

The price index of last year (x) - The price index of this year (y) divided by the price index of last year (x)

Written out in a math problem, it looks like this: x - y / x.

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 economic impacts of a deflationary period is decreased business revenues. Because 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 sell off their investments. Because 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.

Deflation in the United States is very rare; it 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 1930s. 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.