What is Deflation

In common usage deflation is generally considered to be "falling prices". But there is much more to it than that. Often people confuse deflation with disinflation or with Depression (as in "the Great Depression"). These three terms are related but not synonymous.  

According to Investorwords.com  the definition of Deflation is "a decline in general price levels, often caused by a reduction in the supply of money or credit. Deflation can also be brought about by direct contractions in spending, either in the form of a reduction in government spending, personal spending or investment spending. Deflation has often had the side effect of increasing unemployment in an economy, since the process often leads to a lower level of demand in the economy. The opposite of inflation."   

What Causes Deflation?

Although everything said above is true it doesn't present the true nature of deflation.  It tries to define it by presenting several possible causes. For a true understanding of both Inflation and Deflation we need to understand Supply and Demand.  Just like every other commodity there is a supply of and a demand for "Money". 

In this article I am not going to address the issues of what true money is, for the sake of this article we will assume money is simply something other people are willing to accept in exchange for goods or services. 

Price levels  are the direct result of the relationship between the supply and the demand for any given item. But the value of the money used to pay for those items is also subject to the same relationship. 

For the sake of simplicity let's assume that we are on an island and there are ten equally desirable goods in our universe and ten $1.00 bills available to purchase them with. We can safely assume that each item will end up costing $1.00 each.

If the quantity of money increases to $20 (without increasing the quantity of goods) the price of the goods will increase to $2.00 - that is inflation.  

If, however, the quantity of money decreases to $5.00 the price will fall to 50¢ (deflation).  This is what the first part of the above definition is referring to. The money supply can also be reduced if someone on our island hoards half of it and refuses to spend it on anything no matter what. This is the second part of the definition (reduction in spending). 

So far we have only looked at part of the equation, the supply of money.  But what happens if the quantity of goods available increases? What if instead of having ten items we build ten more? We now have twenty items and only $10. 00 so once again each item is worth 50¢. 

This form of deflation is the good type. Everyone assumes that deflation is bad because the last major deflation that we had was during the "Great Depression" so deflation and Depression are synonymous in many peoples minds. In actuality if prices go down because the goods can be manufactured more cheaply this ends up increasing everyone's wealth.

This is exactly what happened in the late 1990s ,  with cheap productivity available from former Communist countries the quantity of goods is increased while the money supply increased at a slower rate.

What about Demand?

What about the demand for goods? If everyone on our island already has one of the items  available and no one needs any more, naturally the price will also fall as sellers try to find someone to take them off their hands.

So far we have dealt with the supply of money, the supply of goods and the demand for goods, but what about the demand for money? 

Is it possible that the demand for money could increase or decrease? Generally, the demand for money is measured by how much people are willing to pay to borrow it (i.e. interest rates). If inflation is high, interest rates will have to be higher to compensate for the loss of purchasing power. But also if the demand for money rises banks can charge more to loan it. Conversely, if the demand for money falls interest rates will also fall.

So there are four causes for Deflation. 

1. Decreasing Money Supply
2. Increasing Supply of Goods
3. Decreasing Demand for Goods
4. Increasing Demand for Money

Note:

Increasing demand or decreasing supply of money have the same result i.e. "tight money" either way people want more money than is available. 

Both could also result in (or cause) higher interest rates. But the higher interest rates should also tend to balance (or decrease the demand for money because it is now more expensive). 

In other words as interest rates rise at some point the demand drops off because people don't want it bad enough to pay such high rates. 

Is Deflation Good or Bad?

Actually, deflation itself is neither good nor bad. It depends on the cause of the deflation whether people will suffer or rejoice. As I said, if the cause is increasing supply of goods that would be good. Another example of this is in the late 1800's as the industrial revolution dramatically increased productivity.

However, if deflation is caused by a decreasing supply of money as in the great depression, that would be bad. The stock market crash sucked all the liquidity out of the market place, the economy contracted, people lost their jobs and then banks stopped loaning money because people were defaulting.  The problem compounded as more people lost their jobs and money supply  fell further  causing more people to lose their jobs, etc. etc.

Note: During the Depression demand for money was high (but no one could afford it) because supply was low.

So deflation can be caused by several different things and thus can be good or bad depending on the cause.

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