Subscribe to newsletter Most economies experience inflation regularly. Inflation represents a specific currency’s purchasing power. A high increase in inflation can result in damage to most economies. Some economies may also experience negative inflation, also known as deflation. While, theoretically, it can be a good thing, it also has some drawbacks.

What is Deflation?

Deflation is an increase in the currency’s purchasing power. Or it refers to the decline in the prices of goods and services. There are several reasons why deflation may occur in an economy. Usually, it relates to supply and demand. When the money or credit supply in an economy decreases, or productivity and the number of goods and services increases, it results in deflation.

How does Deflation work?

Same as inflation, the Consumer Price Index helps calculate the deflation in an economy. However, there are some factors that the index ignores, which can have an impact on it. Therefore, the index may not be a true indicator of inflation or deflation in an economy. When the index in one period for an economy is lower than the previous, inflation is said to have occurred. Deflation usually comes with a negative signal for an economy. It results in a decrease in the money supply in a country due to lower wages, hurts investment portfolios, and even causes unemployment. Therefore, deflation may also accompany a recession in the future. As the deflation in a country increases, the chances of a recession occurring in the future also increase. However, that does not mean deflation can only result in adverse effects. Deflation can also result in increased nominal consumer spending. Since deflation causes an increase in purchasing power of a currency, it means more people can afford items. With the increased spending by consumers, deflation can positively stimulate the economy.

Why is Deflation bad?

Despite its positive effects, deflation is usually bad for the economy. Although deflation can stimulate the economy with increased consumer spending, there is no guarantee that will happen. As the prices of goods and services start declining, consumers will postpone their spending. Usually, this is because they hope the prices will decrease even further in the future. Therefore, deflation slows a country’s economic growth. Due to the decreased spending by customers, manufacturers are forced to reduce their prices. For most consumers, it provides a choice between various products at affordable prices. However, it causes manufacturers to employ cost-cutting measures. Some manufacturers may also suffer significantly and go out of business. Either way, deflation can cause unemployment in an economy aside from its other adverse impacts. Similarly, it decreases a country’s GDP, which can even further magnify the problem. Apart from manufacturers and consumers, deflation can also affect borrowers. They have to repay lenders a higher amount due to the increase in the currency’s purchasing power. Overall, deflation can cause a chain of events that can lead to a severe economic decline. Long periods of continuous deflation can even force economies to go into recession.

Conclusion

Deflation refers to the increase of a currency’s purchasing power. While deflation can have a good effect on an economy, in some cases, it can also impact a country adversely. Deflation can cause a decline in consumer spending as they postpone it, hoping to get lower prices in the future. It can result in lower earnings for manufacturers and can further result in other problems.

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