Deflation

What is deflation?

Deflation is when the economy-wide price of goods decreases, causing a reduction the amount of money in circulation. The opposite of inflation, deflation often occurs during or just before a financial crisis because people tend to hold onto their cash instead of reinvesting it into the economy.

Deeper definition

Deflation is governed by the concept of supply and demand. It can occur when there’s either

  • An increased demand for or decreased supply of money
  • A decreased demand for or increased supply of goods

When the overall price of goods in an economy starts to decrease, people in that economy tend to hoard their cash as they wait for an even lower price. What follows is a decline in the circulation of cash.  That, in turn, increases the purchasing power of currency. When these things happen, businesses either can’t sell their goods and services or have to sell them at lower prices, making their business unprofitable and forcing them to lay off workers. This process is called a deflationary spiral, and it was a major factor in the Panic of 1837 and the Great Depression.

The country’s central bank combats deflation by lowering interest rates, which allows banks to lend more money and stimulate the economy by essentially causing inflation. A little inflation can be a boon in times of deflation, but it can only do so much. If that doesn’t work, the next step government might take is simply to inject more money into the economy, which creates jobs, incomes, and therefore more spending.

Another way to think of deflation is that the real value of debt increases. That means money that a borrower owes to the bank is worth more to the bank, leaving the borrower in further debt. Because she has less money, she may default on her loans, depriving the bank of funds.

Additionally, governments hate deflation because it makes it difficult to fund social services. If there’s less money in the economy, the government is drawing less tax revenue.

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Deflation example

The desert planet of Tatooine is host to a thriving moisture farm economy. This year, each unit of moisture costs $100 on average. That’s a little too much for something with such little demand, so nobody buys it. The cost of a unit of moisture drops to $95 on average.

At the same time, all the Tatooine citizens who are not buying units of moisture essentially see growth in their money: that $100 they didn’t spend is now worth $105. That’s a pretty good deal, so they wait to see if a unit of moisture will drop again.

It does fall again. Even though the price of one unit is now affordable, the people of Tatooine want to see if it’ll go down even further. This time, the farmers producing moisture can’t afford the loss of income. Several major farms close up shop, and laborers in the moisture farm industry are laid off. Now, counting the unemployed, even fewer people are buying moisture, compounding the problem.

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