According to besteducationschools, the term deflation describes a sustained and noticeable decline in the general price level for the goods or services produced in an economy.
In this chapter we will show you what exactly defines deflation, how it occurs and what effects it can have. With the help of our subsequent exercises you can test your knowledge of deflation and prepare yourself for your next exam on this topic.
What is the significance of deflation?
Basically, lowering prices has a positive impact on general welfare in an economy, provided that it is based on an increase in efficiency. In the course of deflation, however, the lowering of prices occurs due to lower demand, which is usually due to lower purchasing power.
As a result of the lower prices , companies lack the money for new investments, or these are postponed, since when prices fall, the profit prospects for investments also decrease.
At the same time, the falling price level reduces consumer spending, as consumers wait for prices to drop even further in order to then buy even more cheaply. The resulting negative cycle can lead to severe economic crises and their consequences to higher unemployment, which further reduces the purchasing power of consumers.
Deflation: economic vicious circle
As a result of the decline in consumption, the tax revenue of the state is also falling, which is also less able to invest. The falling prices and the resulting diminishing profits for companies also make it more difficult to pay existing loans and employee wages.
As a result, there are often numerous bankruptcies of companies, since the credit and wage burdens in particular remain the same, but the value of the goods produced falls. One of the best-known examples of the effects of deflation is the historic Great Depression in the early 1930s.
What is deflation?
While inflation describes an increase in the general price level, deflation is the exact opposite: a decrease in the general price level.
Change in the amount of money in an economy
If measures by the central bank of an economy reduce the amount of money in an economy while the amount of goods produced remains the same, this can result in deflation. Likewise, the money supply within the economy can be reduced by a large surplus of imports, since the liquid funds flow abroad.
Lowering the demand for goods and services
If the demand for goods and services falls sharply within an economy, prices are reduced. The result is deflation, which can develop into a severe economic crisis through further downward spirals. A decline in demand can be triggered, for example, by falling wages or rising unemployment.
Lowering the cost of businesses
If companies can reduce the cost of manufacturing goods, they often produce more of these goods. An excess supply arises, which in turn triggers falling prices.
How can deflation be combated?
Avoiding deflation with all its negative consequences, or fighting it as soon as the first signs appear, is an important task that can be implemented through various measures.
How important this is can be seen from the fact that the European Central Bank (ECB) has made stabilizing the price level within the euro zone one of its main tasks. The ECB’s monetary policy aims to achieve the most stable inflation rate possible of around 2%.
Monetary Policy Measures
Monetary policy measures in the fight against deflation include, for example, lowering interest rates. However, this measure is limited, at the latest when interest rates are close to zero.
Another monetary policy measure can be used the quantitative easing method. Here, the central bank of an economy buys forms of financial investments on the market, such as loans, debentures, bonds, etc., in order to increase the amount of money and thus the liquidity in the market.
Economic Policy Measures
In addition to monetary policy measures, economic policy measures can also be used to avert the risk of deflation. In particular, a demand-oriented economic policy can offer a way out of deflation. Above all, this includes increasing government investment or subsidies to increase demand. At the same time, taxes can be reduced to take the pressure off companies and private households.