What Exactly Is Deflation? Everything You Need To Know

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What is deflation? Is it the opposite of inflation? And if so, is it a good thing?

Before we dive in more, let’s define what inflation is according to Wikipedia: “Inflation is defined as an increase in prices and the fall of the purchasing value of money.”

The truth is, deflation isn’t exactly the opposite of inflation and it’s never a good thing. Read on to find out more about what deflation is really about.

Deflation Definition

Deflation is the reduction of the general level of prices in an economy. While most people like it when prices drop, an all-over drop in prices of goods is bad. It is usually caused by a depression where people can’t afford goods. 

Businesses lower their prices to make their products more affordable, but if prices become too low they will no longer be able to run their business they will be forced to close. Closing businesses causes unemployment to rise so that even more people are unable to buy goods and services resulting in an ongoing downward spiral.

Deflation vs. Inflation 

Here are some key difference between deflation and inflation:

  • Inflation leads to a decrease in the value of money whereas deflation leads to an increase in the value of money. 
  • Some inflation (up to a 2% rate) is good for the economy while deflation will always make the economy deteriorate.
  • Inflation is usually caused by demand and supply factors while deflation is caused by money supply and credit factors.
  • Inflation leads to an uneven distribution of money whereas deflation leads to a reduction of spending and an increase in unemployment. 

Common Causes of Deflation

Deflation is usually caused by a fall in aggregate demand and an increase in aggregate supply. Here are some examples of how it plays out in our economy.

Fall in Money Supply: This occurs when banks increase interest rates causing people to be more conservative with money. It results in higher borrowing costs which discourages consumer spending.

Decline in Confidence: A recession can not only lead to people having less money to spend, it can cause them to be pessimistic about the future so they reduce their spending activity. 

Increases in Aggregate Supply: When production costs are low, businesses tend to increase production. If they produce more supply than meets demand, they will have a surplus of products. They may lower prices to get rid of the surplus, but if they are not meeting their financial goals, they will have to go out of business. 

Fiscal Austerity: If governments cut spending and the wages of public sector workers, there will be a fall in spending. 

Stock Market Fall: When stock markets fall, it can reduce the money supply causing a reduction in spending. 

Debt Leveraging: After a credit bubble, many people will try to pay off their debts and reduce their spending as a result. 

Why is Deflation Bad? 

Deflation sets off a vicious cycle as less spending equals less jobs and less jobs equals less spending. But let’s take a look at how things can carry out on a large scale. 

When people are unemployed, they run out of money which causes them to default on debt obligations like mortgages, loans, credit cards and more. The financial sector must write these debts off as losses and banks begin to lose their stability causing depositors to withdraw their funds.

If too many deposits are redeemed, banks won’t be able to meet their obligations and they may begin to collapse. This reduces the liquidity in the system and it also reduces the supply of credit for those seeking new loans. 

Banks react by enforcing a looser monetary policy including the lowered of interest rates. They will also pump money into the economy through open market operations buying Treasury securities in the open market in return for newly created money. 

If these measures don’t work in stimulating economic growth, banks may begin purchasing riskier private assets in the open market in an attempt to improve the situation. They may also step in as a lender of last resort acting as the provider of liquidity to a financial institution that finds itself unable to obtain sufficient liquidity through other sources.

Governments may try to ease deflation by lowering taxes and increasing government spending. However, the lowering of taxes will limit their income and make them unable to operate at full capacity. 

Deflation in U.S. and Japan

Deflation often has negative effects in the real world and currently it is an ongoing problem in Japan and the United States. 

Japan once had an enviable economic system, but this came to a halt in 1991 when the country entered a period of stagnation. The U.S. followed suit in 2001 with similar problems plaguing both regions. 

Both countries experienced expansion due to investment growth and asset price bubbles. Yet their economies deteriorated after the economy collapsed. 

The U.S. Reserve and the Bank of Japan both responded to the recession by cutting interest rates. However, the Federal Reserve took more aggressive action that may have helped the economy recover more quickly. 

As a result, the U.S. economy is bouncing back while Japan remains stagnant. 

While economists puzzle over Japan’s slow moving process, many attribute it to the fact that officials weren’t aware of how quickly the problem could grow to damage the economy. They further point out that the U.S. has a much larger foreign debt than Japan, clocking in at 43% as compared to Japan’s 13%.

Best Investments for Deflation

Although deflation is never a good thing, it can have more of an affect on some than others. Making the right investments can keep you protected in times of deflation. 

In general, it is best to avoid investing in assets such as cash, gold, real estate and stocks that will be falling during deflation. However, bond funds are recommended. Long term bond funds can be especially lucrative because, as interest rates fall, bond prices will increase. 

Certain sector funds are good to invest in, especially those in defensive areas that provide things people need regardless of economic conditions, like health care and utilities. 

U.S. Government bonds are another good choice as they offer fixed rates in various denominations. You can invest in short term, tax exempt bond funds to lock in a higher yield and lower your taxable income. Mutual funds can help diversify your portfolio while offering better yield rates and some no-load bond funds have low management fees and carry a good interest rate. 

Other good choices include inverse exchange-traded funds, zero coupon stock funds and dividend stock funds. 

Deflation can really weigh down on the economy. A good understanding of what deflation is and knowing the right types of investments to make can help you weather through difficult financial times.

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