What Is Deflation? Why Is It Bad For The Economy?

When prices go down, it’s generally considered a good thing—at least when it comes to your favorite shopping destinations.

When prices go down across the entire economy, however, it’s called deflation, and that’s a whole other ballgame. Deflation is bad news for the economy and your money.

Deflation is when consumer and asset prices decrease over time, and purchasing power increases. Essentially, you can buy more goods or services tomorrow with the same amount of money you have today. This is the mirror image of inflation, which is the gradual increase in prices across the economy.

While deflation may seem like a good thing, it can signal an impending recession and hard economic times. When people feel prices are headed down, they delay purchases in the hopes that they can buy things for less at a later date. But lower spending leads to less income for producers, which can lead to unemployment and higher interest rates.

This negative feedback loop generates higher unemployment, even lower prices and even less spending. In short, deflation leads to more deflation. Throughout most of U.S. history, periods of deflation usually go hand in hand with severe economic downturns.

Deflation is measured using economic indicators like the consumer price index (CPI), which tracks the prices of a group of commonly purchased goods and services and publishes the changes every month.

When the prices measured in aggregate by the CPI are lower in one period than they were in the period before, the economy is experiencing deflation. Conversely, when the prices collectively rise, the economy is experiencing inflation.

Deflation is not to be confused with disinflation. Though they both sound like they would indicate decreases in prices, disinflation actually signifies that prices are still rising, just more slowly than they have been.

Disinflation could be a change from 4% annual inflation to 2% annual inflation, meaning a good that used to cost $10 now retails for $10.20, instead of a projected $10.40.

Deflation, on the other hand, describes actual decreases in prices, not a decrease in the rate that inflation is rising. With 2% deflation, a good that used to cost $10 now costs $9.80.

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There are two big causes of deflation: a decrease in demand or growth in supply. Each is tied back to the fundamental economic relationship between supply and demand. A decline in aggregate demand leads to a fall in the price of goods and services if supply does not change.

A drop in aggregate demand may be triggered by:

Monetary policy. Rising interest rates may lead people to save their cash instead of spending it and may discourage borrowing. Less spending means less demand for goods and services.

Declining confidence. Adverse economic events—such as a global pandemic—may lead to a decrease in overall demand. If people are worried about the economy or unemployment, they may spend less so they can save more.

Higher aggregate supply means that producers may have to lower their prices due to increased competition. This boost in aggregate supply may stem from a drop in production costs: If it costs less to produce goods, companies can make more of them for the same price. This can result in more supply than demand and lower prices.

Although it may seem helpful for the price of goods and services to fall, it can have very negative effects on the economy.

Unemployment. As prices drop, company profits decrease, and some companies may cut costs by laying off workers.

Debt. Interest rates tend to go up in periods of deflation, which makes debt more expensive. Consumers and businesses often decrease spending as a result.

Deflationary spiral. This is a domino effect caused by each overlapping piece of deflation. Falling prices may result in less production. Less production may lead to lower pay. Lower pay may result in a drop in demand. And a drop in demand may cause increasingly lower prices. And on and on. This can make a bad economic situation worse.

When prices go up and the power of the dollar goes down, the economy is experiencing inflation.

While inflation means your dollar doesn’t stretch as far, it also reduces the value of debt, so borrowers keep borrowing and debtors keep paying their bills. Modest inflation is a normal of the economic cycle—the economy typically experiences inflation of 1% to 3% per year—and a small amount is generally viewed as a sign of healthy economic growth.

Inflation is also something consumers can protect themselves against to a certain extent. Investing your money, for instance, can help your earnings grow faster than inflation, helping you retain and grow your purchasing power.

While it may seem worse for prices to rise than to fall, deflation is generally less favorable and is associated with economic contractions and recessions. A deflationary spiral may turn hard economic times into recessions and then depressions.

Protecting yourself against deflation is also a little trickier than safeguarding against inflation. Unlike with inflation, debt becomes more expensive with deflation, leading people and businesses to avoid taking it on as they try to pay off the increasingly pricy debts they already owe.

During periods of deflation, the best place for people to hold money is generally in cash investments, which don’t earn much, if any, returns. Other types of investments, like stocks, corporate bonds, and real estate investments, are riskier when there’s deflation because businesses can face very difficult times or fail entirely.

The government has a few strategies to rein in deflation.

Boost the money supply. The Federal Reserve can buy back treasury securities to increase the supply of money. With a greater supply, each dollar is less valuable, encouraging people to spend money and raising prices.

Make borrowing easier. The Fed might ask banks to boost the amount of credit available or lower interest rates so people can borrow more. If the Fed lowers the reserve rate, which is the amount of cash commercial banks must have on hand, banks can loan out more money. This encourages spending and helps raise prices.

Manage fiscal policy. If the government bumps up public expenditures and cuts taxes, it can boost both aggregate demand and disposable income, leading to more spending and higher prices.

Overall, the United States has primarily experienced inflation, not deflation. But during some periods, deflation has shaped the economies of the U.S. and elsewhere:

Deflation was an accelerator of one of the toughest U.S. economic periods, the Great Depression. Although it began as a recession in 1929, rapidly decreasing demand for goods and services caused prices to drop significantly, which led to the collapse of many companies and rising rates of unemployment. Between the summer of 1929 and early 1933, the wholesale price index fell 33%, and unemployment peaked at above 20%.

Price deflation due to the Great Depression happened in virtually every other industrialized country in the world. In the U.S., output didn’t return to the previous long-term trend path until 1942.

Japan has experienced a state of mild deflation since the mid-1990s. In fact, the Japanese CPI has been almost always slightly negative since 1998, except for a brief period before the 2007-08 global financial crisis.

Some experts have pinned this problem to Japan’s output gap—the difference between the Japanese economy’s actual and potential output. Others suggest that insufficient monetary easing is the issue.

In any event, the Bank of Japan currently has a negative interest rate policy, a monetary policy that slightly penalizes people for holding onto money in an attempt to combat deflation.

There was much concern about deflation in the U.S. recession spanning late 2007 to mid-2009. Commodity prices fell, and debtors found it harder to repay loans. The stock market was down, unemployment was up, and home prices dropped precipitously.

Economists were concerned that deflation would lead to a deep downward economic spiral, but that didn’t happen. One study published in the American Journal of Macroeconomics suggests that the financial crisis at the beginning of the period managed to prop up inflation.

Because interest rates were so high at the onset of the recession, some companies couldn’t afford to drop prices, which may have helped the economy avoid widespread deflation.

Deflation is the overall decrease in the cost of an economy’s goods and services. While a slight decrease in prices may spur consumer spending, broad deflation can discourage spending and lead to even greater deflation and economic downturns.

Thankfully, deflation doesn’t happen often, and when it does occur, governments and central banks have tools to minimize its impact.