Deflation: Definition and how it affects you

Deflation is a decrease in the general price level of goods and services. To put it another way, during periods of deflation, you pay less for the things you typically buy. It’s the opposite of inflation and is sometimes referred to as a negative inflation rate. Deflation causes a currency to become more valuable because falling prices allow consumers to buy more with the same amount of money.

In the United States, the government tracks inflation and deflation using the Consumer Price Index (CPI), a measurement of the average change over time in the prices of a set of representative goods and services. It’s a sort of snapshot of what the average American is buying and includes food products, energy, education, transportation, and more. When there’s a decrease in the prices of those purchases over a prolonged period of time, deflation has taken place.

There are two main causes of deflation and both relate to the well-known economic principle of supply and demand.

Decreased demand for goods and services

Deflation due to a decline in aggregate demand happens when consumers are less willing to spend money. When consumers aren’t spending, producers are forced to lower the prices of goods and services to entice them.

Decreased consumer demand may happen when consumers become nervous about the future of the economy. During troubling world events like wars, global pandemics, or environmental disasters, people often decide to save their money. 

Demand can also decrease because central banks, like the Federal Reserve, have restricted the supply of money by raising interest rates or taxes. One main reason they do this is to counteract too much inflation. With higher interest rates, borrowing money becomes more expensive, so people are less willing to take out loans to make big purchases. 

Increased supply of goods and services 

A decline in production costs for things like energy and raw materials enables producers to make more products. But if consumer demand doesn’t keep up with the increased supply, producers will have to lower their prices to entice customers. 

Technological advances that lead to increased productivity can also spur aggregate supply and, consequently, lower consumer prices.

Lower prices might seem like a good thing, especially when it means your grocery budget stretches a lot further than it used to. But while stronger purchasing power is a bonus in the moment, deflation is generally considered a problem.

Bad deflation

When producers lower their prices, they have to cut costs in other areas, often lowering wages or laying off workers. This can then set off a chain reaction known as a deflationary spiral. Laid-off employees then decrease their spending, furthering a fall in demand, and deflation increases, leading to a lower rate of economic growth. 

Deflationary spirals can intensify an economic recession, which is exactly what happened during the Great Depression in the 1930s. After the stock market crashed, companies collapsed, and unemployment skyrocketed. A panicked public withdrew its money from the banks and stopped spending resulting in the most dramatic period of price deflation the country has ever seen. 

More recently, deflation played a role in the Great Recession of 2007-2008, which was sparked by the collapse of a housing bubble. The subsequent wave of mortgage payment failures and resulting bank foreclosures made consumers fearful and decreased demand in the economy. At the same time, the Fed failed to inject enough money into circulation in response, and the country underwent a period of deflation.

Good deflation

While deflation can be a harbinger of declining economic activity, moderate deflation caused by innovation can be normal—and even a good thing, especially in sectors of the economy that experience frequent technological improvements. For example, smartphones were prohibitively expensive when they were first introduced. But over time, we’ve gotten better at making smartphones cheaper and more efficiently, which allows the producers to offer them at lower price points.

While it’s always nice to see a cheaper grocery bill, it’s a good idea to keep in mind the big-picture effects of deflation. For you it might mean less expensive bananas, canned soups, and dried pasta, but it also means that people up and down the supply line—from the agriculture workers picking the fruits and vegetables, to the factory workers packaging the products, to the truck drivers delivering them to your grocery store—might be facing unemployment as producers cut costs. 

If deflation begins to expand throughout the economy, your industry might end up facing cutbacks and unemployment as well. More immediately, you might have to pay higher taxes or have a harder time taking out a loan. Here are a few things you can do to protect yourself against deflation:

• Have a thoughtful financial plan and an emergency fund in place. 

• Keep your debts to a minimum to reduce the negative effects you feel from any period of deflation. 

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