Deflation is the opposite of inflation. It refers to a general fall in the level of prices. Typically, this will occur when there is a general fall in demand for goods – for example, if people are spending less through uncertainties over rising unemployment.

Deflation is a phenomenon of persistent and continuous falling prices. In its initial and later stages it maybe respectively referred to as recession and depression

Causes of deflation

– Deflation is usually caused by falling aggregate demand, which means the total demand in the economy is not able to buy all(or enough) goods and services in the economy. When this happens, the prices will fall.

– Deflation can also happen if the productive potential of the economy increases, which leads to excess supply over demand.

– Excess use of deflationary fiscal and monetary policies also could lead to deflation. Governments often use deflationary monetary and fiscal policies to control inflation. However, when the government miscalculates and use those policies too much, deflation could happen.

Costs of deflation

1. Lower business incentive
When the prices fall, the incentive to invest and expand is less, therefore growth of business slows down, and sometimes there is negative growth if businesses start getting bankrupt. This is a very serious type of deflation.

2. Unemployment increases
When there is deflation, firms are often forced to lay-off workers in order to reduce loss. And when people become unemployed, their ability to demand for goods and services also decline.

3. Real cost of borrowing increases.
This can happen if the nominal interest rate remains the same. When deflation happens, returns to the investment declines, which could lead to difficulties in repaying the loans taken.

4. Holding back on spending
Consumers may opt to postpone demand if they expect prices to fall further in the future.

Is deflation always a problem?

Benign Deflation
If falling prices are caused by higher productivity, as happened in the late 19th century, then it can go hand in hand with robust growth. On the other hand, if deflation reflects a slump in demand and persistent excess capacity, it can be dangerous, as it was in the 1930s, triggering a downward spiral of demand and prices. If the falling prices are simply the result of improving technology or better managerial practices, that is fine.

Malign Deflation
Malign deflation occurs when prices fall because of a structural lack of demand which creates huge excess capacity in an economic system. If there is a slump in demand, companies go out of business and sack people, and hence demand falls again – the negative multiplier effect starts to have its effect.

Next topic: Changing patterns and levels of employment

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