Deflation is a fall in the overall level of prices in an economy and an increase in the purchasing power of the currency. It can be driven by an increase in productivity and the abundance of goods and services, by a decrease in total or aggregate demand, or by a decrease in the supply of money and credit.

Key Takeaways Deflation is when the general price levels in a country are falling—as opposed to inflation when prices rise.

Deflation can be caused by an increase in productivity, a decrease in overall demand, or a decrease in the volume of credit in the economy.

Most of the time, deflation is unambiguously a positive trend for the economy, but it can also under certain conditions occur along with a contraction in the economy.

In an economy dominated by debt fueled asset price bubbles, deflation can lead to a temporary financial crisis and period of liquidation of speculative investment known as debt deflation.

Understanding Deflation

Changes in consumer prices can be observed in economic statistics compiled in most nations by comparing changes of a basket of diverse goods and products to an index. In the U.S. the Consumer Price Index (CPI) is the most commonly referenced index for evaluating inflation rates.﻿﻿ When the index in one period is lower than in the previous period, the general level of prices has declined, indicating that the economy is experiencing deflation.

This general decrease in prices is a good thing because it gives consumers greater purchasing power. To some degree, moderate drops in certain products, such as food or energy, even have some positive effect on increasing nominal consumer spending. Beyond these basic staples, a general, persistent fall in all prices not only allows people to consume more but can promote economic growth and stability by enhancing the function of money as a store of value and encouraging real saving.

However, under certain circumstances rapid deflation can be associated with a short term contraction of economic activity. In general this can occur when an economy is heavily laden with debt and dependent on the continuous expansion of the supply of credit to inflate asset prices by financing speculative investment, and subsequently when the volume of credit contracts, asset prices fall, and speculative over-investments are liquidated. This process is sometimes known as debt deflation. Otherwise, deflation is normally a positive feature of a healthy, growing economy that reflects technological progress, increasing abundance, and rising standards of living.

Deflation: Causes and Effects

If, as the common saying goes, inflation is the result of too much money chasing not enough goods in the economy, then conversely deflation can be understood as a growing supply of goods and services being chased by a constant or slower-growing supply of money. This means that deflation can be brought about either by an increase in the supply of goods and services or by a lack of increase (or decrease) in the supply of money and credit. In either case, if prices can adjust downward, then this results in a generally falling price level.

An increase in the supply of goods and services in an economy typically results from technological progress, the discovery of new resources, or an increase in productivity. Consumer’s purchasing power increases over time and their living standards rise as the increasing value of their wages and business incomes allow them to purchase, use and consume more and better quality goods and services. This is an unambiguously positive process for the economy and society as a whole.

At times some economists have expressed fears that falling prices would paradoxically reduce consumption by inducing consumers to hold out or delay purchases in order to pay lower prices in the future. However, there is little evidence that this actually occurs during normal periods of economic growth accompanied by falling prices due to improvements in productivity, technology or resource availability.

Moreover, the vast majority of consumption is made up of goods and services that are not easily deferred to the future even if consumers wanted to, such as food, clothing, housing services, transportation and healthcare. Beyond these basic needs, even for luxury and discretionary spending consumers would only choose to reduce current spending if they expect the rate of decrease in prices to outweigh their natural time-preference for present consumption over future consumption. The one type of consumer spending that would suffer from falling prices would be items that are routinely financed by taking on large debts, since the real value of fixed debt will increase over time as prices fall.

Debt, Speculation, and Debt Deflation

Under specific conditions, deflation can also occur in and after periods of economic crisis.

In a highly financialized economy, where a central bank, another monetary authority, or the banking system in general engages in continually expansion of the supply of money and credit in the economy, reliance on newly created credit to finance business operations, consumer spending, and financial speculation, which results in ongoing inflation in the commodity prices, rents, wages, consumer prices and asset prices.

More and more investment activity starts to take on the form of speculation on the price appreciation of financial and other assets, rather than profit and dividend payments on fundamentally sound economic activity. Businesses activities tend likewise to depend more and more on the circulation and turnover of newly created credit rather than real savings to finance ongoing operations. Consumers also come to finance more and more of their spending by borrowing heavily rather than self-financing out of ongoing saving.

To compound the problem, this inflationary process usually involves the suppression of market interest rates, which distorts decisions about the type and time horizon of business investment projects themselves, beyond simply how they are financed. Conditions become ripe for debt deflation to set in at the first sign of trouble.

At that point, either a real economic shock or a correction in market interest rates can put pressure on heavily indebted businesses, consumers, and investment speculators. Some of them have trouble revolving, refinancing, or making their payments on various debt obligations such as business loans, mortgages, car loans, student loans, and credit cards. The resulting delinquencies and defaults lead to debt liquidation and writedowns of bad debts by lenders, which start to eat away some of the accumulated supply of circulating credit in the economy.

Banks' balance sheets become shakier, and depositors may seek to withdraw their funds as cash in case the bank fails. A bank run may ensue, whereby banks have over extended loans and liabilities against inadequate cash reserves and the bank can no longer meet its own obligations. Financial institutions begin to collapse, removing liquidity that indebted borrowers have become even more desperate for.

This reduction in the supply of money and credit then reduces the ability of consumers, businesses, and speculative investors to continue to borrow and bid up asset and consumer goods prices, so that prices may stop rising or even begin to fall. Falling prices put even more pressure on indebted businesses, consumers, and investors because the nominal value of their debts remain fixed as the corresponding nominal value of their revenues, incomes, and collateral falls through price deflation. And at that point the cycle of debt and price deflation feeds back on itself.

In the near-term this process of debt deflation involves a wave of business failures, personal bankruptcies, and increasing unemployment. The economy experiences a recession and economic output slows as debt financed consumption and investment drop.

The Bottom Line

A little bit of deflation is a product of, and good for, economic growth. But, in the case of an economy-wide, central bank fueled debt bubble followed by debt deflation when the bubble bursts, rapidly falling prices can go hand-in-hand with financial crisis and recession. Thankfully, the period of debt deflation and recession that follows is temporary, and can be avoided entirely if the perennial temptation to inflate the supply of money and credit in the first place can be resisted.

All in all, it is not deflation, but the inflationary period that then leads to debt deflation that is dangerous for a country's economy. Perhaps unfortunately, consistent and repeated inflation of these kind of debt bubbles by central banks has become the norm over the past century or so. At the end of the day this means that while these policies persist, deflation will continue to be associated with the damage they cause to the economy.