What Is Deflation?

Definition & Examples of Deflation

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Deflation is a decrease in the general prices of goods and services within an economy. It occurs when the rate of inflation becomes negative. This differs from disinflation, which is only a slowdown in the rate of inflation (and marks the speed of that change). With deflation comes a gain in the buying power of currency. In other words, you may have the same amount of money, but since prices are lower, your dollar will stretch further.

Learn more about deflation, how it occurs, and the effects it can have on stocks, bonds, and other market metrics.

What Is Deflation?

Deflation is an increase in the real value of money as it relates to goods and services. This means you can purchase more with $1 in a negative inflation economy than you could in a positive inflation economy. Inflation and deflation are both measured using the Consumer Price Index (CPI), which measures the prices of a selection of goods and services that a typical consumer might purchase, spread over a set amount of time.

The rate of deflation can be calculated as follows:

  1. First, look at the price index of the current year (CPIc) and the price index of the previous year (CPIp). Subtract the current year (CPIc) from the previous year (CPIp).
  2. Next, divide the result by the CPI from the previous period.
  3. Lastly, multiply the result by 100 to get a percentage.

The formula for the rate of deflation looks like this:

(( CPIc - CPIp ) / CPIc ) * 100 = Deflation Rate

How Deflation Works

Deflation can be caused in a number of ways. It is often caused by a fall in the total demand of goods and services, or an increase in supply. (This makes sense, since supply and demand are inversely related.) It can also be cause by a lack of money supply. It works like this: if consumers reduce their spending, demand will go down, causing supply to go up and prices to go down. Investors see prices falling and begin to sell. Panic ensues, and the market takes a nosedive.

When prices are falling, people often curb their spending even more until prices bottom out. This pattern can compound the problem further.

There are several ways to counteract deflation and its effects, but not everyone agrees on the methods. In fact, this is the topic of an ongoing debate in various economic camps. Many believe in flooding the economy with cash, which will in turn promote spending. By this logic, injecting more capital into an economy is the only way to reverse deflation for certain, since it attempts to change the only part of the equation that they can control: the money supply.

Alternative Methods

In recent years, the Federal Reserve introduced a method called quantitative easing. This approach attempts to increase inflation from the market end. To conduct quantitative easing, the Fed starts by cutting the federal fund rate. This is the interest rate banks charge each other for overnight loans. The Fed would then purchase a large number of long-term bonds, which will decrease the value of bonds, and increase inflation.

Whether or not this unconventional tactic has the desired effect is still up for debate. The aim of policies such as these is to combat deflation by using the powers of the Fed to decrease the dollar's value. The Fed can decrease the value of the dollar through an increase of the money supply or a decrease in the value of bonds.

How Deflation Affects the Market

For the most part, people agree that deflation has a negative impact on stocks, since lower prices over a long span of time tend to hurt bottom-line corporate net income. To add to the problem, deflation might encourage consumers to save money and reduce spending. This practice also has a negative impact on top-line revenues, and erodes shareholder value.

While deflation is bad for stocks, it can have a positive impact on some types of bonds. Government debt, such as that bought and sold in the form of U.S. Treasury Bonds, is worth more because fixed payments take on greater value. This happens because interest rates tend to decrease during a deflationary period, which leads to increases in bond prices and profits for people who have bonds.

Deflation isn't always a good thing for corporate bonds, however, especially those in companies that aren't blue-chip stocks. Deflation makes it tougher to make debt payments each year, since they become more costly. This puts companies at risk because in time they will not be able to pay their debts.

Pros and Cons of Deflation

Pros
  • Lower prices on goods and services

  • Cheaper to borrow money

  • Shrinks wealth gap

Cons
  • Lower wages for workers

  • Rise in unemployment levels

Pros Explained

  • Lower prices: When deflation occurs, consumers spend less money, which drives down demand. This drop in demand and increase in supply leads to a decline in prices because businesses have to lower prices to get rid of their inventory.
  • Cheaper to borrow money: As a way of combating deflation, the Federal Reserve will often lower interest rates to try to get people to spend more and invest less in fixed-income investments like bonds. The low interest rates also mean people can borrow money for much cheaper, which is helpful for big ticket purchases things like cars, homes, or other items that may need to be purchased with a loan.
  • Shrinks wealth gap: The value of most assets falls during deflation. Since people with more wealth are more like to hold assets than cash, they will suffer a greater loss compared to people with less wealth. On the flip side, people with lower income and mostly cash assets (rather than stocks or bonds), will benefit from the rising value of the dollar.

Cons Explained

  • Lower wages for workers: As people hold on to their money and start to spend less, businesses also lose money. Drops in drops in profit means they don't have as much to pay employees, let alone offer raises.
  • Higher unemployment: An increase in supply means that companies have to reduce their production of goods. Cutting down production means less labor is needed, and may lead to layoffs. In some cases factories or retail stores may permanently close. This not only hurts current workers, but it limits the pool of jobs open for people just starting to enter the workforce.

Key Takeaways

  • Deflation occurs when the value of the dollar increases and the cost of goods and services drop.
  • Deflation can cause an increase in unemployment figures and wage drops.
  • People who are wealthy will suffer from greater losses during deflation because assets are more likely to decrease in value.
  • The Federal Reserve tries to slow down deflation by increasing the money supply and encouraging spending.