Deflation is when prices decrease throughout the economy. It is the opposite of inflation and most commonly associated with a contraction of the money supply, a drop in aggregate demand and technological progress.
When there is less money chasing the same number of goods and services, prices decrease. Since the Great Depression, central banks and economists mostly view deflation as a negative thing. In order to prevent deflation and stimulate spending, central banks aim for mild inflation.
When the money supply grows at the same rate as goods and services, they are in an equilibrium. In this case, prices remain stable. However, changes in the money supply can result in more or less units of money chasing the same number of goods and services.
This leads to disequilibrium in the form of inflation or deflation. When the money supply expands, prices increase. And when the money supply contracts, prices decrease.
These assumptions are based on the Quantity Theory of Money which stems from the monetary school of economic thought that explains inflation and deflation as monetary phenomena.
Apart from the money supply, deflation can also occur when aggregate demand drops. Let’s say a company suddenly experiences a reduction in demand for its products.
The company has already paid for the products and stores them in its warehouse. In order to avoid sitting on supply that doesn’t sell, the company decides to lower prices.
As prices decrease, people start buying the products again. The falling prices brought supply and demand back into an equilibrium.
The same can happen on a macroeconomic scale. When demand as a whole for all goods and services throughout the economy decreases, the general price level falls. This is known as aggregate demand. A reduction in aggregate demand, combined with an unchanged aggregate supply, causes deflation.
Increases in economic productivity, especially in the form of technological progress, can lead to deflation as well. When we produce more goods and services using less time, energy, resources and labor, prices tend to decrease.
This deflationary effect is especially noticeable in the technology sector. The first mobile phone was clunky and could barely do anything. But it cost $3,995 in 1983.[1] Mobile Phone Museum: “Motorola DynaTAC 8000x” Accessed April 28, 2022. Adjusted to inflation, this equals to more than $10,000 today.
Several decades later, smart phones come with built-in GPS, cameras, calculators and internet browsers. They are small computers that fit into our pockets. But the efficiency of microchips has steadily gone up while the cost of computers has decreased.
As a result, smart phones are cheaper today than basic mobile phones were in the 80s. Laptops and personal computers have better processors and more computing power than large industrial machines had in the 90s but they are significantly cheaper today.
The most famous episode of deflation occurred during the Great Depression. At the time, a cascade of bank failures led to a contraction of the money supply.
As banks failed, many individuals and companies lost money, leading to further defaults on loans and mortgages.
This triggered a vicious circle of continued bank failures. People hoarded the little money they had left. As the money supply contracted and demand for goods and services collapsed, prices of commodities, food and general consumer items dropped sharply.
This deflationary depression and went down in history as one of the worst economic crises.
In response to the deflationary crisis, many countries abandoned the gold standard. Under the gold standard, governments had limits to how much money they could create.
All paper money had to be backed to a certain percentage by gold. Because Americans hoarded their gold during the Great Depression, president Roosevelt issued Executive Order 6102, which outlawed private gold ownership and took the United States off the gold standard.[2] The American Presidency Project. “Executive Order 6102—Requiring Gold Coin, Gold Bullion and Gold Certificates to Be Delivered to the Government” Accessed Feb. 24, 2022.
After 1933, the United States began expanding the money supply more aggressively. The Federal Reserve was still a young institution at the time. It was founded in 1913, two decades before the United States left the gold standard.
The Federal Reserve’s involvement in monetary policy, and specifically it’s role in preventing deflation, increased as central bankers and economists reviewed the factors that contributed to the Great Depression.
According the the Federal Reserve’s own accounts, it didn’t do enough to dampen the effects of the Great Depression.[3] Federal Reserve History: “The Great Depression” Accessed April 28, 2022.
In retrospect, the Fed believes it should have done more to lift the United States out of deflation. Ben Bernanke, former chair of the Federal Reserve, expressed that his goal was to make sure “it” didn’t happen again.[4] Federal Reserve Bank of St. Louise “Deflation: Making Sure “It” Doesn’t Happen Here : Remarks before the National Economists Club, Washington, D.C.” Accessed April 28, … Continue reading “It” specifically referred to deflation, similar to the one experienced in the 1930s.
Ever since the Great Depression, most economists and central bankers view deflation as something negative. Instead of deflation, the Federal Reserve and other central banks aim for mild inflation to stimulate spending.[5] Board of Governors of the Federal Reserve System: “What is an acceptable level of inflation?” Accessed April 28, 2022.
During the Global Financial Crisis of 2008, Bernanke was chair of the Federal Reserve. Having learned from the Fed’s past mistakes during the Great Depression, he quickly lowered the Federal Funds Rate to zero percent.[6] Federal Reserve Bank of St. Louis: “Federal Funds Effective Rate” Accessed April 22, 2022.
And for the first time in history, the Federal Reserve deployed a Quantitative Easing program to purchase mortgage-backed securities and government bonds.[7] Federal Reserve: “Federal Reserve announces it will initiate a program to purchase the direct obligations of housing-related government-sponsored enterprises and mortgage-backed securities … Continue reading
Lowering the Federal Funds rate and Quantitative Easing are both ways to expand the money supply and counteract deflation.
An even larger-scale Quantitative Easing program was launched in response to the Covid-19 pandemic to stimulate the economy and prevent deflation from occurring.
Japan struggled with a mild deflationary period during the 1990s.[8] Bank of International Settlements: “Chronic Deflation in Japan” Accessed April 28, 2022. While the economic circumstances were different than the Great Depression and Global Financial Crisis, the Bank of Japan engaged a long-term Quantitative Easing program in an attempt to counteract deflation.[9] Bank of Japan: “New Procedures for Money Market Operations and Monetary Easing” Accessed April. 8, 2022.
The program was only mildly effective, showing that the relationship between money supply and inflation isn’t always as clear and pronounced as economic models suggest.
When central banks engage in Quantitative Easing, they purchase assets like mortgage-backed securities, corporate bonds and government bonds. These assets are purchased with money that the central bank essentially creates “out of thin air”.
This is why Quantitative Easing is sometimes referred to as printing money. Lowering short-term interest rates and Quantitative Easing are the two main ways central banks conduct monetary policy to combat deflation.
Inflation tends to benefit people who borrow money because they can pay back their debt with money that has lost purchasing power.
They owe the same amount in nominal terms, but in real terms the value of the money decreases. This is why industrialists like Hugo Stinnes made fortunes during the German hyperinflation.[10] Taylor, Frederick: The Downfall Of Money. Germany’s Hyperinflation And the Destruction Of The Middle Class (2014), pp. 206ff.
Stinnes borrowed money and bought businesses. By the time he had to repay the loan, the money was essentially worthless. He was left with a real asset that preserved its value, while paying for it with money that was worthless.
On the other hand, deflation puts pressure on borrowers. The value of the borrowed money increases, which means by the time the debt has to be repaid, the borrower might not be able to service the debt.
Deflation increases the likelihood of default. It punishes individuals, businesses and governments that are heavily indebted.
Since the Great Depression, deflation has become something economists and central banks attempt to avoid at all cost.
However, the link between deflation and depression isn’t entirely clear. A study by Andrew Atkeson and Patrick Kehoe examined economic depressions across 17 countries in the last 100 years.[11] National Bureau of Economic Research: “Deflation and Depression: Is There an Empirical Link?” Accessed April 28, 2022.
They found a link between depression and deflation in the 1930s, which coincides with the Great Depression. But they failed to find a correlation or causal relationship between depression and deflation during other economic depressions throughout history.
Several proponents of heterodox economic schools have proposed that deflation isn’t necessarily a bad thing.[12] Hülsmann, Guido Jörg: Deflation and Liberty (2008).
According to them, the money supply doesn’t influence the total amount of goods and services and the wealth of a society. An expansion of the money supply doesn’t make society richer. On the flip side, a contraction of the money supply doesn’t make society poorer.
They view both inflation and deflation as phenomena that benefit different groups of people. To them, inflation benefits those with the ability to incur the most debt, including governments that use inflation to lessen their debt burden.
Deflation, on the other hand, punishes those that live on credit and benefits those that save money. They argue that deflation is simply shunned because we live in a credit-based and overindebted society.
In an economy where consumption and investing were based on saving, deflation wouldn’t necessarily be something bad. Some argue that deflation could be beneficial and lead to more spending long-term.
If people are incentivized to save and adopt a longer time horizon, they could make larger investments in the future, stimulating the economy in a more sustainable way.
Deflation could also increase people’s purchasing power as long as wages fall slower than prices. Given the same wage, deflation caused by technology enriches the amount of goods and services and individual can afford, therefore enhancing the person’s wealth.
Despite these alternative theories, most economists unanimously agree that deflation is bad for the economy.
However, in recent years, overindebted governments and increased inflation have sparked interest in revisiting the debate about inflation and deflation.