Deflation

Falling prices, called deflation, can originate from both the demand and supply side.

Deflation can be ‘benign’ and caused by improvements in supply which lower costs. As its name suggests, this kind of deflation is not problematic as it can provide a stimulus to consumption, and growth.

Deflation can also be ‘malign’ - caused by falling aggregate demand, and this is problematic as it signifies a deeper problem of a lack of aggregate demand.

In general, an extended period of deflation is problematic as it tends to mean that consumption is deferred as consumers wait for prices to fall further.

The two types can occur together in a deflationary spiral.

Deflation

Deflation is a relatively rare phenomenon in the modern era, given as central banks target their monetary policy specifically to achieve low levels of inflation (usually around 2%), rather than deflation. However, there have been significant periods when deflation persisted - especially during the inter-war years. The chart below identifies two deflationary periods in US history including the periods 1920-1921 and 1927-1933 (including the Great Depression years, 1930 to 1933.)

Deflation is closely associated with rising and persistent unemployment, both as a symptom of deflation and as a cause of it. Along with unemployment comes the likelihood of rising poverty and inequality.

A period of deflation is likely to become embedded given that the most significant effect of falling prices is, perhaps, that it encourage consumers to defer their current consumption in the hope that goods will get even cheaper in the longer run.

Video on deflation

Debt burdens also increase as a fall in average prices increase real interest rates. The real interest rate is the nominal rate, less inflation, hence deflation causes real rates to rise. For example, if the nominal rate is 5% and deflation is (-) 2% then real rates are 7% (5% + 2%).

It is clear there is a significant macro-economic problem for those countries that experience malign deflation.

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