April 9, 2021

What is Deflation?

Deflation is an important term we should pay close attention to. Although it is not common to hear there is deflation in an economy, this can happen. Basically, deflation is the decline in prices of goods and services in a specific region. 

Deflation is an important term we should pay close attention to. Although it is not common to hear there is deflation in an economy, this can happen. Basically, deflation is the decline in prices of goods and services in a specific region. 

There are many factors that influence the evolution of prices. In this guide, we are going to share with you what falling prices mean, how disinflation works and deflation definition, among other things.

What is Deflation?

As we mentioned before, deflation is a situation in which the prices of an economy start falling. No matter if we are talking about goods or services, the prices would tend to fall. This does not mean that all the prices would fall. However, if an economy experiences deflation most of the prices measured by the CPI should fall.

Deflation occurs when there is a contraction of the money supply in the economy. If there are fewer monetary units available for people, then prices should fall trying to find an equilibrium. This is exactly the contrary process as inflation. 

When we talk about falling prices, we should understand that for the same money we should be able to buy more things. Let’s use an example. If we were able to buy 1 litre of milk for $1 last year, if we experienced a deflation rate of 10%, the price of 1 litre of milk should now be $0.90. 

That means that with $1 we are not able to buy more milk than a year ago. This is how deflation grows. At some point having falling prices seems to be a positive thing. With the same money, you earn you are able to buy more things. 

However, it is highly possible that if there is deflation in the region where you are, you should also be affected by it. That means you might have a lower salary or fewer sales (earnings). 

Causes of Deflation

Some of the main causes of deflation include a fall in the money supply, decline of confidence in the economy, technological improvements and a more efficient economy. 

Reduction in the Money Supply

A fall in the money supply would directly affect consumer prices. If there is less circulating money, then people would definitely be more cautious about the way in which they use their money. 

Considering that people know their money is worth more (the same monetary units buys more things than in the past) individuals prefer to save the money rather than spend it today. This increases the effects of deflation. 

One of the ways governments have to reduce the money supply is by increasing interest rates. This encourages savings and reduces the circulation of money in the economy. 

People Become Less Confident in the Economy

One of the reasons behind falling prices could also be a decline in the confidence of an economy. What does it mean? It basically means that if there is a recession or a bad economic situation, people prefer to reduce their spendings and increase their savings. 

If interest rates are higher, then this could help people save their money. However, if interest rates are low, people would prefer to have their money and wait rather than spending it. Some central banks are searching for ways of pushing interest rates even lower (negative). This would affect savers that would prefer to store their money outside banks. 

Deflation takes place usually during recessions. We should also take into consideration that this could increase the number of unemployed people in the economy considering firms should cut costs to deal with inflation. 

In some cases, when there is deflation, we could see a deflation spiral. That means that the prices of goods and services go down and this pushes for lower salaries, cuts in production and reduced money in the economy that incentivizes deflation. If that happens, then deflation would accelerate or at least continue for a longer period of time. Nevertheless, once the market reaches an equilibrium the recession would end and the economy would start working again. 

Technological Improvements 

Another way in which we could see deflation in an economy is through technological improvements. Companies are also able to offer better services and products at a lower price. 

For example, if a company purchased a new production machine that doubles the production rate they had before, they are now able to sell these products at a lower price. This could be very positive for an economy, becoming more efficient than others. 

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