Deflation is, unfortunately, an economic phenomenon that occurs from time to time. This severe drop in assets and prices across an entire economy can be a major problem for any market, as the effects of deflation usually persist over extended periods.
Deflation can eventually result in fewer business profits, lower employment rates, employee wage cuts, and investment losses.
It becomes more severe as economic conditions worsen, making it even more difficult to break the cycle. In fact, doing so can take years.
Read on to learn more about deflation, how it happens, how it's measured, and a list of real-world examples.
What is deflation?
Deflation is the complete opposite of inflation, which is the steady increase in prices across any given market. Both good and bad deflation exists, and deciphering one from the other depends on how extreme it becomes. What matters most is that there is a severe shrinkage in the money supply.
The length of deflationary periods tends to vary.
What causes deflation?
A decrease in prices isn't necessarily a bad thing. Generally, consumers consider it favorable, as items like clothing, gas, or stocks are more affordable, and your dollar is worth more. But a prolonged period of deflation leads to a recession.
The two major causes of deflation are a decrease in demand and a growing supply.
Decrease in demand
Typically, when prices drop, consumers will hold off on buying and wait to see the lowest price for any particular item.
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This occurs parallel to a decrease in demand and means that, because consumers are refraining from spending, more products are available than are being sold. Interest rates rise when this occurs, which further discourages spending.
The halt in spending means businesses have to keep dropping prices to encourage people to buy. Sales and profits suffer as a result.
A negative feedback loop arises, which is often difficult to break. In other words, deflation creates more deflation, similar to the snowball effect that often occurs with interest rates.
How is deflation measured?
The Consumer Price Index, or CPI, is the instrument used to evaluate deflation. This index records the prices of goods and services over long periods but publishes their findings each month. Continually low prices mean that the economy is suffering from deflation.
However, the CPI does not consider stocks or the value of homes in their measurements, which are two significant factors that can heavily influence many people's wealth.
Deflation can also be measured using a nation's gross domestic product, or GDP.
What are the effects of deflation?
Deflation can lead to detrimental effects on any economy, including the most noteworthy:
Laying off workers is a typical response during economic downturns. When companies cannot make sufficient profits, they can't afford to pay their staff their current salaries, let alone pay them at all.
Since people are buying less, businesses will respond by slowing down or even forestalling production.
Higher interest rates
When prices drop, a nation's real interest rate shifts. This refers to interest rates that are adjusted to reflect the value of products more accurately. In response, people spend less to save more due to low consumer confidence.
Again, interest rates tend to rise during deflationary periods, which increases personal and professional debt. The accompanying payments are more costly, too. In turn, this can lead to compounding interest.
How can a government control deflation?
Since deflation is usually a nationwide occurrence, the federal government can take steps to ensure this phenomenon stays under control.
One: Boost the money supply. Simply put, treasury securities are financial instruments used to manage debt. Governments can issue more of them or repurchase them from investors to increase the money supply. These types of securities have a high degree of liquidity, meaning they are easily converted into cash. More money means your dollar is not worth as much, so people are more likely to spend, which, in turn, raises prices.
Two: Make borrowing easier. Governments can also request that banks increase their limits on credit loans and decrease interest rates so people can borrow larger amounts. In addition, governments can also lower the threshold of how much money a bank must have on hand, known as the reserve rate. This also encourages financial institutions to loan out more money.
Three: Manage fiscal policy. Tax reductions and increasing public spending creates demand, jobs, and disposable income, all of which help get prices back under control.
Deflation versus disinflation
Despite the similarities in spelling, deflation and disinflation are two different concepts. Nevertheless, it is important to be aware of each.
Again, deflation refers to the widespread falling of prices from year to year. A skewed relationship between supply and demand is what triggers economic deflation.
Furthermore, since deflation and inflation have a hostile relationship, declining prices cause inflation rates to plummet below zero.
This happens when price inflation slows down temporarily. Unlike deflation, it is a short-term event. It does not precede economic disaster.
Disinflation illustrates how quickly inflation rates shift over time. The prices of goods and services don't drop; they are simply not growing at a healthy pace.
3 examples of deflation in history
The Great Depression
America's Great Depression, starting in 1929 and continuing into the 1930s, is arguably the best-known example of real-world deflation.
A significant drop in demand, supply, and prices led to the collapse of companies across the country, and even the collapse of banks themselves.
The events of the Great Depression echoed across the globe and took a toll on the markets in other countries as well. It took until 1942 for the country to recover.
The Great Recession
Once again, the United States is home to one of the most infamous periods of economic hardship. From 2007 to 2009, stock and commodity prices fell, leaving borrowers unable to repay loans. Unemployment rose, and the housing market took an enormous hit.
Deflation in Japan
Known as the "Lost Decade," from 1991 to 2001, the Japanese economy experienced a prolonged period of deflation. But before the 1990s, Japan's economy was one of the most productive, growing more than four percent each year.
The primary causes of this downturn were skyrocketing interest rates and falling equity rates. As a result, a "liquidity trap" occurred. This is when investors sit on their cash because they will earn better returns instead of investing or spending it. Typically, they do this because deflation is just around the corner.
As a nation, Japan managed to recover but did so slowly.
Made to spend.