What Is Deflation?

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DEFINITION

Deflation is a decrease in the general prices of goods and services within an economy.

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. You may have the same amount of money but your dollar will stretch further because prices are lower.

Definition and Example of Deflation

Deflation is an increase in the real value of money as it relates to goods and services. 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). The CIP 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 like this:

  1. 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. Divide the result by the CPI from the previous period.
  3. 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 brought about by a fall in the total demand of goods and services, or an increase in supply. And this makes sense because supply and demand are inversely related.

It can also be caused by a lack of money supply. Demand will go down if consumers reduce their spending, causing supply to go up and prices to go down. Investors see prices falling and begin to sell. Panic ensues. The market takes a nosedive.

People often curb their spending even more when prices are falling 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 best methods. This is the topic of an ongoing debate in various economic camps. Many believe in flooding the economy with cash. This will in turn promote spending. Injecting more capital into an economy is the only way to reverse deflation for certain by this logic, because it attempts to change the only part of the equation that can be controlled: the money supply.

Alternative Methods

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

Whether this unconventional tactic has the desired effect is still open to 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

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

Deflation is bad for stocks, but 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 because they become more costly. This puts companies at risk because in time they won't 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: Consumers spend less money when deflation occurs. This drives down demand. The drop in demand and the increase in supply leads to a decline in prices. Businesses have to lower prices to get rid of their inventory.
  • Cheaper to borrow money: The Federal Reserve will often lower interest rates as a way of combating deflation, trying 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 much more cheaply. This is helpful for big ticket purchases like cars, homes, or other items that may need to be purchased with loans.
  • Shrinks wealth gap: The value of most assets falls during deflation. People with more wealth are more likely to hold assets than cash, so they'll 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: Businesses also lose money as people hold on to their money and begin to spend less. Drops in drops in profit mean 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. This can lead to layoffs. Factories or retail stores may permanently close in some cases. This not only hurts current workers. It also limits the pool of jobs open for people who are just starting to enter the workforce.

Key Takeaways

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

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