Your Ultimate Cheat Sheet to Deflation

When a bubble bursts, gauging what will happen can be difficult. Sometimes inflation floods the market. Other times economies spiral into a deflationary phase. Here’s Your Ultimate Cheat Sheet™ to Deflation:

What is Deflation?

Deflation is a decline in prices caused by a decreasing supply of money. As less money circulates in the economy, sellers are forced to lower prices so buyers have enough money to continue making economic transactions.

How is Deflation Measured?

The Department of Labor measures the value of our money by analyzing monthly price changes in 400 items people typically buy. This data is then averaged into the Consumer-Price Index so we can see whether prices are inflating or deflating over time.

We can see deflation when basic items such as bread and milk cost less. The same is true for energy (e.g., gas, electricity), housing, and clothes.

Is Deflation Good?

Deflation seems like a good thing because when items come down in price, the standard of living can increase. However, when prices deflate drastically or over a long period of time, deflation can harm business revenues and cause layoffs. The extreme example is the Great Depression.

What is a Deflationary Spiral?

Once prices begin to deflate, this can set off a feedback loop that further harms the market. When prices are deflated in the long-term, this will cause firms to lower their production levels, leading to lower wages. When people are making less money, demand for goods and services will decrease. As demand falls, prices deflate. When prices deflate, the cycle starts over and we end up in a deflationary spiral.

How Do We Avoid a Deflationary Spiral?

Typically we can rely on Central Banks (e.g., Federal Reserve, European Central Bank, Central Bank of China, etc.) to increase the money supply. This counteracts deflation by increasing the amount of money “chasing” goods and services, in turn allowing sellers to increase prices again.

Central Banks are responsible for maintaining an equilibrium money supply to keep the economy regulated. However, in the event deflation gets to the point where monetary policy no longer has power to stop the deflationary cycle, we call this a liquidity trap.

Intermediate-Level Concept: As prices keep sinking, the nominal interest rate declines below the real interest rate. As the demand for money turns inelastic (i.e., having money is just as valuable as investing it), investors choose to hoard money rather than invest. This further lowers aggregate demand. This cycle can keep reinforcing itself as an economy sinks deeper into depression.

What’s the Best Way to Deal with Deflation?

The debate to fix deflation is a two-sided issue. Keynesians believe the best solution is to pursue an expansive fiscal policy in which the government spends money to stimulate the economy. Examples include Franklin Roosevelt’s New Deal, or more recently the American Reinvestment and Recovery Act.

However, the Monetarists would rather undergo a process of quantitative easing where bank reserves are increased and the central bank increases the money supply by purchasing long-term government bonds and securities.

Regardless of the solution you prefer, the effects of widespread deflation can pose disastrous consequences for investors and workers. Catching and containing deflation is vital for a healthy economy.

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