Five key contributors to economic deflation

We hear a lot about inflation, and at the moment, with inflation rising, it is a major topic of conversation in the US and a significant political issue.

Inflation can be bad news, but inflation’s evil twin is much worse. In fact, deflation is so unwelcome that you won’t hear business news anchors or TV economists talk about it very much, although fortunately, it is a comparatively rarer economic phenomenon than inflation. But what is deflation and what causes it?

What is deflation

Inflation is technically a measure of the rate of growth of prices for goods and services in an economy, and deflation is the measure of the decline of prices. Low inflation is the normal state of price increases that governments are hoping to encourage, and it is preferable to high inflation, which has negative effects on the value of a nation’s currency and on people’s purchasing power.

Yet while low inflation is generally considered a good thing, when the change in the prices of goods and services moves into a deflationary pattern, it is bad news.

The effects of deflation

Typically, deflation occurs at a time of national recession, and it can have many exacerbating negative effects on the economy.

One of these is an increase in unemployment. When price levels are dropping, producers often attempt to cut their costs, which in many cases means laying off employees. Deflation is also linked with increasing interest rates, causing a rise in the cost of debt. This means that businesses and households are less likely to invest or spend.

Just as high inflation can create a spiral of increasing wage demands and interest rates, deflation can produce its own negative spiral. Decreasing prices can lead to lower production, decreased demand, lower wages and even lower price levels. At a time of economic difficulties, such as a recession, the deflationary spiral can exacerbate the situation.

Causes of deflation

Economists generally attribute deflation to one of two main categories of causation:

• A fall in aggregate demand
• An increase in aggregate supply

Three of the main deflationary causes are associated with a fall in demand, while two contribute to a rise in aggregate supply.

1. Fall in the money supply

One of the most common contributing factors to deflation is when a central bank such as the Federal Reserve makes the decision to increase interest rates. Higher interest rates make saving more attractive, so there is an overall increase in the number of people saving, rather than spending. At the same time, the higher cost of borrowing that results from increased interest rates also discourages spending, adding further to declining demand.

2. Decline in confidence

During a recession or a negative economic event, people and businesses may take a pessimistic view of the overall situation. A decline in consumer and business confidence can also lead to an increase in saving and a decrease in spending, which feeds into falling demand.

3. Fiscal austerity

During times of economic difficulty, governments may take drastic steps to cut deficits and national debt. Some nations, such as the UK, took this step in the wake of the 2008 global banking crisis. Major reductions in government spending feed into the wider economy through state employees, welfare recipients and businesses with government contracts, and contribute to falling demand.

4. Fall in commodity prices

The first major contributor to an increase in aggregate supply, which in turn causes deflation, is a fall in key commodity prices, of which oil is a prime example. When oil prices fall, producers are able to increase their rate of production, leading to oversupply and eventually a further drop in prices.

5. Technological advances

The second cause of increased supply is new technology. The implementation of technologies that reduce production costs enable producers to increase their rate of production, leading to oversupply and a subsequent fall in prices.

Summary

Deflation is an unwelcome economic phenomenon. It can make a bad recession even worse and can have an exacerbating effect on businesses and households that are already struggling.

It is, fortunately, rarer than high inflation, and both governments and central banks are keenly aware of the possibility of deflation, so they will attempt to prevent it from occurring. Nevertheless, it occurs in all economies from time to time. Understanding what deflation is and where it comes from can help you to spot it ahead of time and to take steps to protect your household, business and investments.