Deflation in economics refers to a general decline in the price of goods. Deflation is the opposite of inflation, and is sometimes referred to as negative inflation. Everyone knows inflation is bad, with its rising prices and falling value of money, but that does not mean deflation is a good thing. On the contrary, periods of deflation are usually accompanied by reduced investment, limited growth and rising unemployment.
Deflation occurs when the annual inflation rate dips below zero percent. During deflation, money gains value because of an overall decline in prices. The term deflation refers to a sustained drop in prices, rather than just a temporary decline.
Historically, many economic thinkers regarded deflation as a problem that would correct itself. They reasoned that a period of declining price levels would naturally stimulate demand. Increased buying by consumers in response to lower prices would reduce supply, eventually causing prices to increase again.
The Great Depression of the 1930s, however, shattered this view. During the Depression, the United States’ gross domestic product (GDP) fell 24 percent. Declining prices were especially hard on farmers, whose incomes plunged because of the lower prices they received from selling their crops.
Deflation is usually associated with recessions, in which aggregate demand for goods and services declines, while unemployment rises. Severe drops in demand across the economy can usher in a depression, as was the case during the 1930s.
Deflation discourages investment because of the prospect of negative profits. It also penalizes holders of non-liquid assets, such as real estate, because the lower prices reduce the value of those assets.
Because deflation increases the purchasing power of money, it benefits holders of liquid assets, such as cash savings accounts, money markets and Treasury notes.
It is important not to confuse deflation with disinflation. The latter refers to a decline in the rate of inflation, while the former occurs when the rate of inflation falls below zero percent. A decline in the rate of inflation from 3 percent to 1.5 percent is disinflation, while a decline from 2 percent to minus 1 percent is deflation.
Severe deflation struck Japan’s economy in the early 1990s after a collapse in real estate prices. The declines forced many individuals and companies with extensive real estate investments into insolvency.
In early 2009, Ireland’s Central Statistics Office reported that the country experienced its first deflation since 1960.
Some economists contend that the United States economy entered a period of deflation in 2008 because of the global financial crisis and credit crunch that occurred that year, and the recession that followed.