Deflation: How the decrease in prices affects the economy and purchasing power

Key Points

Deflation is a phenomenon where the prices of goods and services fall, which theoretically increases the value of your money. It sounds appealing - more cheap items, more savings. But not everything is that simple. With prolonged deflation, the economy can slip into stagnation, growth can slow, and unemployment can rise. In reality, episodes of problematic deflation are rare, but when they occur, the consequences can be serious. Japan has proven this with years of low-speed deflation.

What are we talking about when we talk about deflation?

Simply put, deflation means that the overall price level of the economy is decreasing. It seems good at first - your money is worth more. But when we apply the logic, problems quickly become apparent. When prices fall, consumers postpone purchases, expecting even lower prices. This reduces demand, which creates a perpetual cycle of decline.

Why does deflation occur?

Users are reducing expenses

When households and businesses decide to spend less money, demand falls. When everyone thinks twice before buying something, businesses do not sell enough and prices drop.

Production exceeds the inquiry

Imagine that factories produce so many goods that there are no buyers. This surplus supply often forces companies to lower prices. Sometimes the reason is new technology that makes production cheaper and faster.

Strong national currency

When your currency is strong, you can import foreign goods more cheaply. This directly reduces prices within the country. On the other hand, a strong currency makes exports expensive for foreigners, so local exports decrease.

What is the difference between deflation and inflation?

Two opposite phenomena

Inflation is when prices rise, deflation is when they fall. It sounds simple, but the consequences are very different. With inflation, your money is worth less every day, so people are eager to spend. With deflation, it's the opposite - people wait for prices to drop further and postpone purchases.

Different reasons, different problems

Inflation occurs when there is excessive demand, higher production costs, or when central banks release a lot of money into the economy. Deflation arises from the opposite - less demand, more supply, or new technologies that reduce costs. In the real world, it is usually a combination of several factors.

Economic effects

In inflation, the economy can overheat - prices rise, money loses value, people spend quickly. In deflation, the economy freezes - consumers hold back, companies reduce production, unemployment rises. The two are like two sides of the same problem.

How do central banks fight deflation?

Governments and central banks have two main weapons.

Monetary policy - the easy solution of central banks

Central banks are lowering interest rates. Lower interest rates make loans cheaper - it is cheaper for businesses to take out a loan for development, and it is cheaper for you to buy a home. This stimulates spending and investments.

Alternatively, it is quantitative easing, where the central bank prints more money and injects it into the economy. This way, there is more money in the hands of people who spend more.

Fiscal policy - the state spends

The government can increase its spending - building bridges, hiring people, financing projects. This directly creates demand in the economy.

Either it lowers taxes, giving more money to consumers and companies. When people have more disposable income, they usually spend more.

What are the positive aspects of deflation?

More Affordable Items: In deflation, the value of money increases. This means that, generally, goods become cheaper. For people with fixed incomes, this improves the standard of living.

Cost Reduction: Companies receive relief - raw materials and services are cheaper. This may allow businesses to think about development and expansion.

Increasing Savings: When your money is worth more tomorrow than today, people are more motivated to save. This is positive for people's personal finances.

What is the negative side of deflation?

Users stop buying: When they know that prices will fall, people postpone purchases. Why buy today if you can buy even cheaper next month? This reduces demand and slows economic growth.

Debt Strengthens: The money you owe is worth more. If you took a loan at 10% interest before inflation, it becomes even more painful to pay it off during deflation. Borrowers suffer, which is particularly problematic for households and businesses with large debts.

More people are losing their jobs: When businesses see a decrease in sales due to declining consumption, they typically respond with layoffs. This pushes unemployment up and creates social tension.

Conclusion

Deflation - the decrease in overall prices in the economy - may sound appealing on the surface. Cheaper goods, stronger money, more savings. But long-term deflation creates a problem: consumers and companies stop spending, the economy stagnates, and unemployment rises. Central banks work hard to maintain the importance of inflation at healthy levels - usually around 2% annually. Because neither excessive inflation nor deflation is good for the economy. Balance is everything.