Deflation in Economics: Definition, Cause and Effects

Deflation is the lowering of the cost of goods and services over time. It’s the opposite of inflation, which is the gradual increase of prices in the economy over time.

You may think deflation is beneficial, especially as a consumer, since purchasing power increases, allowing the same amount of money to procure more assets or services. However, it also brings disadvantages to others. Borrowers are a prime example. They’ll pay their existing debt using money worth more than they originally borrowed.

Countries are just as (if not more) wary of deflation than inflation because of the possibility of triggering an economic recession.

Lower prices for goods and services are the marks of deflation. Consumers typically attempt to delay purchases in the hopes that prices will lower further. However, when people spend less, production companies begin having problems — their income decreases, which may eventually lead to unemployment.

Several factors contribute to deflation. The lack of consumer demand is only one. Sometimes, reduced government spending plays a part, as well as a decrease in money supply and business investments. An increase in supply is also a contributor, such as when technological advances result in higher productivity or lower production costs.

The biggest concern about deflation is that it may lead to a recession. Businesses have less income because of the lowered demand, and, as a result, they lay people off. Worse, some companies go bankrupt, which increases unemployment. All this leads to lower income, which causes consumers to stop spending, lowering the demand. Businesses try to compensate by lowering prices further, resulting in less revenue.

When you look at it, you'll see a dangerous economic cycle. As the recession worsens, deflation does too. The federal reserve increases the country's money supply in the hopes of triggering spending. The logic is that as people start spending, the demand for goods increases, breaking the cycle.

However, the effects of deflation aren't 100% negative. It produces positive economic outcomes in some scenarios, depending on several factors. Consider the reason for the price drop and how much. A mild deflation may not be an issue, but if it continues for an extended period, it can become detrimental to the economy.

Discussions about deflation always paint it as something unfavorable for the economy. However, a study by Bordo, Land and Redish in 2004 found that good deflation was possible. Part of the challenge is the expectation it creates among consumers. The longer people try to push back purchases in the hopes of buying goods at a lower price, the lower demand becomes. This trend begins the deflation spiral.

As an example, consider the Perfect Competition. It's a market structure operating under ideal conditions where all suppliers are equal and provide homogenous products. There is also a balance between supply and demand. It forces a lower price for the benefit of consumers.

Although most people see deflation from a macro perspective, it can have very significant effects on your personal finances. When prices first lower, consumers enjoy a period where their income remains steady, allowing them to purchase more with their money. However, when its effects take hold, you'll start feeling it in different areas, such as your household budget and debt management.

Unemployment tends to increase, resulting in lower incomes for households. Unfortunately, the interest rate on your loan won't change. Technically, your debt remains at the same level before deflation. As a result, the money you set aside for repayment takes up a larger portion of your earnings, leaving you less for other expenses. If you have a mortgage or auto loan, you may begin defaulting on your dues, which may cause you to lose your assets.

Several factors lead to deflation. However, remember that these will always tie into the relationship between supply and demand. For example, businesses may strategically lower prices to encourage people to continue purchasing if there is a lower demand for consumer goods. They typically use the same strategy when there's a surplus of supply and they need inventory to move.

MoneyGeek identifies four factors that cause it. These manifest in various ways in the real world but often lead to the same economic effect.

A decrease in prices makes the value of money higher. After all, you can buy more goods or procure more services without spending more. However, when people notice the price decline, they tend to wait before making purchases. The logic is that if they wait long enough, they might get what they want for an even lower price.

Unfortunately, less spending leads to deflation. Households with lower income are less likely to purchase goods. Lenders may also start charging higher interest rates, discouraging people from borrowing.

The total demand for all domestically-produced goods is called aggregate demand. It refers to all assets and services that households, businesses and governments buy. It even includes those exported to foreign buyers. So, spending your money on locally-made goods positively impacts the economy because there's more money circulating.

However, when the demand drops, and there's more than enough supply, most businesses strategically move to lower prices. Their objective is to keep the goods attractive to consumers by making them more affordable. Over an extended period, it can lead to deflation.

Aggregate supply doesn't just refer to the total goods produced by an economy — it factors in its relationship to price levels. So, it's the number of goods and services businesses intend to sell at a given rate and is usually represented by a supply curve.

The relationship between these elements — goods produced and price — is positive. The more businesses think they can sell a product, the more they want to make. However, lower production costs allow firms to produce more without spending more. It may lead to an oversupply, and if the level of demand remains the same, prices must decrease to keep businesses competitive.

Businesses find more ways to increase productivity in a technologically advanced economy. It may lead to several events that cause prices to lower.

Take a manufacturing plant, for example. Automating multiple processes may decrease the need for labor, potentially leading to layoffs. With households having less income, people are more likely to start saving than continue spending. Another effect of automation (or other technological innovations) is a reduced cost of production. Businesses can produce more goods for the same amount of money, increasing aggregate supply.

If you're wondering whether deflation is good or bad for the economy, the answer depends on which goods and services are being affected and how steep the prices are declining. To determine the latter, it’s crucial to understand how deflation is measured.

Our guide explores the Consumer Price Index, the primary indicator for deflation and inflation. If the calculation produces a number greater than 100, it's inflation. Conversely, a figure less than 100 indicates deflation.

The Consumer Price Index (CPI) monitors the average change in price for commonly purchased goods (“basket of goods”) over time. There are over 200 classifications, but the Bureau of Labor Statistics narrows them down to eight categories:

• Food and beverages
• Transportation (including gasoline)
• Recreation
• Education and communication
• Housing costs
• Medical and personal care services
• Apparel
• Other goods and services

Let's say you want to calculate the deflation rate between Year X and Year Y. First, subtract Year X's CPI (Old CPI) from Year Y's CPI (New CPI). Next, divide the difference by Year X's CPI (Old CPI). Finally, multiply the result by 100. The product is your deflation rate for the covered period.

Let’s use sample figures to demonstrate how the formula works. The Old CPI is 215.3 and the New CPI is 214.5. Here’s a step-by-step calculation:

• 214.5 - 215.3 = -0.8
• -0.8 ÷ 215.3 = -0.0037
• -0.0037 x 100 = -0.4

Historically, inflation is more common than deflation. Still, there have been several instances in the last three decades where deflation significantly impacted two individual economies: Japan's and the United States'. Our guide further explores these occurrences and breaks them down in detail, showing what triggered these events and the effects on their respective economies.

Japan was considered an economic superpower in the 80s. However, it experienced a financial crisis for approximately a decade. The years between 1991 to 2001 are popularly known as Japan's Lost Decade. In 2022, more than two decades later, Japan's economy is still struggling. MoneyGeek explores the various events that contributed to Japan's ongoing deflation challenge.

Let's start a decade before the Lost Decade began. Japan decreased interest rates in response to the second oil crisis of 1979. It led to an economic boom, where the country invested heavily in research and innovation.

The Plaza Accords of 1985 marked the beginning of Japan's asset bubble. After selling a significant portion of its Dollar reserve, the Japanese Yen began appreciating. The Bank of Japan lowered interest rates, which encouraged borrowing. The value of property and stocks skyrocketed. The bubble increased the value of people's money, making them all rich. However, in 1989, the Bank of Japan began raising interest rates, and this act triggered Japan's economic decline.

In the 90s, people found themselves with mortgages and homes that had lost their value. Selling it wasn't enough to pay off their debt, so people stopped spending, which caused a steep decline in demand. Anyone who had existing debt experienced the same thing and had the same response — to stop spending. The deflation spiral had begun.

The Bank of Japan implemented quantitative spending in the early 2000s, which involved purchasing government and corporate bonds and stocks to increase the money supply and stimulate economic activities like spending and borrowing. It wasn't until 2006 that mild inflation occurred. Unfortunately, Japan's economy was exportation-dependent, and when the demand for cars crashed in Europe and the U.S., it found itself in another financial crisis.

The introduction of Abenomics in 2012 improved Japan's economic growth, but it remains slower compared to other industrialized countries. Its shrinking population is another challenge. With fewer people working, households have lower incomes, which translates to less demand for goods. Companies didn't replace retired workers because of automation. All these factors continue to contribute to Japan's deflation and stagnation problem.

Deflation isn't always born out of a steep decline in demand — although it eventually played a part in the oil price crash from 2014 to 2016. Prices began to lower around June 2014, when a barrel cost $107.95. The sharp plunge brought oil prices to $44.08 per barrel by January 2015 — almost a 60% drop in about seven months.

This time, an increased supply of petroleum, mainly from the United States, triggered it. The result was one of the most significant price drops in recent times. MoneyGeek explores other factors contributing to this economic event.

The graph above shows how oil prices fluctuated from 2007 to 2022. Rates were at their highest from 2011 to 2013, hitting a triple-digit price. It was mainly due to the growing economies of the U.S. and China, increasing demand.

The decline began in 2014, but the dramatic decrease wasn't apparent until the following year. Once it did, it continued until 2017. Several factors contributed to this, namely an increase in petroleum supply, a decline in worldwide demand and the introduction of new technologies.

The increase in supply came primarily from the United States, which increased its domestic production of oil. Horizontal drilling and hydraulic fracturing — new technologies at that time — allowed it to produce 1 million barrels daily.

The Organization of Petroleum Producing Countries (OPEC) considered slowing down production because of the low prices. Venezuela, Iran and Ecuador were worried about their respective economies and supported it. Saudi Arabia, however, did not and continued its production.

The decline in demand began in the second half of 2014 due to the economic slowdown in China and Europe. There was also a growing movement for energy-efficient activities — cars and airplanes were becoming more fuel efficient, lowering demand further and keeping oil prices at an all-time low.

The subject of deflation can be overwhelming, particularly if you're unfamiliar with it. MoneyGeek's guide lists several commonly asked questions to help provide clarity and further information.

Deflation is a broad topic, and it's connected to so many other financial concepts. Fortunately, MoneyGeek has more than enough resources to help you manage your finances no matter the economic climate.

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