When you notice prices dropping at your favorite stores it’s generally thought of as a good thing, and normally it is. When prices start dropping across the entire economy, it’s a whole different story.
What is Deflation?
Deflation is when prices decrease over time, and purchasing power increases. Basically, you can buy more goods or services tomorrow with the same amount of money you have today. This is the mirror image of inflation, which is the gradual increase in prices across the economy.
While deflation may seem like a good thing, it can signal an impending recession and hard economic times. When people feel prices are headed down, they delay purchases in the hopes that they can buy things for less at a later date. But lower spending leads to less income for producers, which can lead to unemployment and higher interest rates.
How do you measure Deflation?
Deflation is measured by using the consumer Price Index (CPI), which tracks the prices of commonly purchased goods and services. The CPI publishes price changes monthly.
What causes deflation?
The two biggest causes are a decrease in demand and a growth in supply, both tie track back to the economic relationship between supply and demand. A decline in aggregate demand leads to a fall in the price of goods and services.
A drop in demand may be triggered by:
Monetary policy: Rising interest rates may lead people to save their cash instead of spending it, it may also discourage borrowing. If people are spending less the demand lowers.
Declining confidence: Adverse economic events—such as a global pandemic—may lead to a decrease in demand. If people are worried about the economy or unemployment, they may spend less and save more.
Higher supply means that producers may have to lower their prices due to increased competition.
Why is deflation bad?
While it may seem helpful for the price of goods and services to fall, it can have very negative effects on the economy.
Unemployment. Workers will be laid off when prices drop as company profits decrease.
Debt. People (consumers and business) will often decrease their spending once interest rates rise making their debt more expensive.
How to control deflation
The government has a few strategies to control deflation.
Boost the money supply. The Federal Reserve can buy back treasury securities to increase the supply of money. With a greater supply, each dollar is less valuable, encouraging people to spend money and raising prices.
Make borrowing easier. The Fed might ask banks to lower interest rates so people can borrow more without their debt being too expensive. If the Fed lowers the reserve rate, which is the amount of cash commercial banks must have on hand, banks can loan out more money. This can encourage spending and help raise prices.
Manage fiscal policy. If the government bumps up public expenditures and cuts taxes, it can boost both aggregate demand and disposable income, leading to more spending and higher prices.