What It Means
Deflation is a general fall in the prices of goods and services in an economy over an extended period of time. Under conditions of deflation, money gains value relative to all the products that are available for sale in the economy, so buyers can buy more with their money. Deflation is the opposite of inflation, a general rise in prices that causes money to lose value.
Money, whether it is made of gold, stone, paper, or any other material, is only valuable because a society agrees that it has value. There is no actual value in a dollar bill. Americans simply agree that it has a certain value because the U.S. government promises that it does. But the government does not have the power to say exactly how many dollars each individual product in the United States is worth at any given time. The value, in dollars, of each automobile, gallon of milk, doctor visit, and home in the United States is determined by such market forces as supply (the amount of any good or service that a seller is willing to sell at a given price) and demand (the amount of any good or service that buyers are willing to buy at a given price). The value of money shifts in relation to the prices of products over time.
On the surface, deflation might seem like a positive economic development. For one, it makes consumers’ money more valuable and subsequently gives greater purchasing power to individuals. In the short term, deflation can be particularly advantageous to creditors (people who lend money); the money paid back by debtors (people who borrow money) is suddenly worth more than when the loans originated. On the whole, however, deflation can be extremely harmful to the economy. When prices fall, businesses have a harder time making a profit. As a result, they will be likely to produce less of whatever it is they sell, which means that they will need fewer workers in the production process. Workers who lose their jobs also lose their capacity and willingness to buy products. If job cuts occur on an economy-wide scale, consumer demand for products diminishes. Prices continue to fall as a result of this lack of demand, and companies further restrict production and lay off more workers. Individual debtors are hit even harder by this downward turn, as they must contend not only with layoffs and decreased wages but also with the costs of repaying loans with money that has increased in value. Companies with debts suffer in a similar way, as decreased profits make it harder to repay loans. In this respect, deflation is ultimately bad for creditors as well, as fewer debtors are able to repay their debts. Such a self-perpetuating situation, known as a deflationary spiral, is typical of depressions (severe economic crises) and can take a long time to correct.
When Did It Begin
Deflation, like inflation, is a concern in any money-based economy. Money itself is believed to have been used as early as 3000 bc in ancient Mesopotamia (the region between the Tigris and Euphrates Rivers in an area spanning parts of present-day Iraq, Syria, and Turkey).
The Great Depression (the severe economic crisis that afflicted North America and Europe in the 1930s) is the most prominent example of a deflationary spiral in modern times. During the depression prices fell by about 25 percent in the United States. Accordingly, output (the quantity of goods produced) fell by roughly the same amount, and unemployment (the percentage of people who wanted jobs but could not find them) surpassed 25 percent. Since workers could not afford to buy products, businesses had no incentive to increase output; hence, they did not hire new workers, and the cycle continued.
Government intervention was necessary to spur recovery from the depression. By spending money on large projects (which required workers) and on direct aid payments to impoverished citizens, the U.S. government increased demand. People with money were able to buy what they needed and wanted, and companies had an incentive to increase production. This required hiring more new workers, which had the effect of further increasing demand.
Since the depression national governments have played an active role in maintaining the value of their currencies. They make decisions about government spending and about the amount of money in circulation with a view toward minimizing the harmful effects of inflation and deflation.
More Detailed Information
The value of money, like the value of products, is affected by the forces of supply and demand. When the money supply (the amount of money in circulation in an economy) is large compared to the supply of goods available for sale in the economy, then inflation can result. There is less demand for money under conditions of inflation than there is for goods. Although prices rise during inflationary times (as businesses, responding to increased consumer demand, try to increase their profits), consumers are nevertheless likely to spend money on items they need and want, since holding onto actual dollar bills is equivalent to losing money because a dollar will continue to lose value for as long as a period of inflation exists. Therefore consumers are likely to spend money on items they need or want, and individuals and businesses are likely to invest money (in bank accounts that collect interest, in the stock market, or in a company expansion, for example) so that their savings grow faster than the rate of inflation. When consumers demand large quantities of goods at the same time that individuals and businesses are eager to invest their money, economic growth is likely to occur. If, however, inflation gets out of hand and prices skyrocket, people cannot make enough money to purchase the goods and services that they need and want. They might demand higher wages, and if business owners comply, the higher wages will push inflation still higher.
Deflation occurs under inverse conditions. If the supply of products in the economy increases faster than the money supply, then there will be more demand for money than for products. If the value of money continues to increase relative to the value of goods, people will naturally want to hold onto their money in the hope that it will buy more goods in the future than it will today, and prices will fall. In the short term this may not be a problem. Recessions (periods of time during which an economy shrinks instead of grows), which can occur when companies respond to falling prices by cutting back on production, are natural and unavoidable periods in any economy’ functioning. Persistent deflation, however, can prolong a recession or increase the intensity of its effects, and a deflationary spiral is a worst-case scenario for any economy. Deflationary spirals are characteristic of severe economic crises, such as the Great Depression.
In today’s world modest rates of inflation are considered desirable. The central bank of the United States, the Federal Reserve System (commonly called the Fed), attempts to keep inflation at around 3 percent a year, a level consistent with long-term economic health. It does this by changing the amount of money in circulation. The Fed increases or decreases the amount of money in circulation depending on many factors, including the supply of goods and services at any given time.
The threat of a deflationary spiral is generally seen as more distant than the threat of excess inflation. When the Fed attempts to keep inflation under control by decreasing the amount of money in circulation, however, it must guard against excess deflation.
In the late twentieth century economists and government leaders worried more about inflation than deflation. Indeed, inflation had been a much bigger problem for the U.S. economy in the 1970s and 1980s, and the government’s increased ability to guard against economic crises made a return to depression-style deflation seem unlikely.
Fears of deflation in the world economy were awakened, however, in the 1990s, when Japan (the world’s second-largest economy) went into a recession. Together with government mismanagement of the economy, the recession triggered a prolonged period of deflation. The Japanese economy was in and out of recession from 1992 through 2003, and during much of that time, the general level of prices continued to fall. While these economic conditions in Japan never approached the extremity of conditions in countries affected by the Great Depression, many economists and ordinary people were made newly aware of the possible threats posed by a period of deflation. As of 2006 Japan’s economy was recovering, but deflation had not been entirely overcome.
Deflation is a general and sustained reduction in the level of prices. It is the opposite of inflation. Falling prices may seem to bring widespread benefits to society, making everything more affordable; in reality, deflation may pose serious dangers. Falling prices are usually a sign that economic activity is slowing down to an alarming degree. That means that companies take in less money and make less profit; therefore, they can hire fewer workers and they may have to lay off those they have. Falling prices also mean that fewer companies will be able to invest in new plants and equipment. Failures to modernize can often hurt companies in the long run. With smaller paychecks, families will buy less, which further dampens economic activity. Extreme examples of deflation, most notably the Great Depression (1929–1939) of the 1930s, have been marked by hardship and high unemployment. In general, economists prefer that prices neither rise nor fall too quickly; they instead prefer to see prices remain steady over time.
See also: Inflation, Price
de·fla·tion / diˈflāshən/ • n. 1. the action or process of deflating or being deflated.2. Econ. reduction of the general level of prices in an economy.3. Geol. the removal of particles of rock, sand, etc., by the wind.DERIVATIVES: de·fla·tion·ist / -ist/ n. & adj.