What is Deflation?

Deflation is a decline in price levels. It is the opposite of inflation in the sense that inflation usually leads to rising prices. However, while consumers may welcome a decline in price levels in one sense, deflation can be a very dangerous situation. Economies, in general, do not like severe inflation or deflation and both can be volatile situations fraught with worries.

Just as inflation makes money less valuable, deflation makes money more valuable. As such, deflation can happen at times when interest rates are high and the lock on money is tight, thus creating a situation where there is a reduction in credit. In fact, there are four reasons why deflation can happen. Either there is an increased demand for money, an increased supply of goods, a decreased supply of money or a decreased demand for goods.

The most common way to fight fears of deflation is likely for the national bank to increase the supply of money. In the United States, this job falls to the Federal Reserve. Most other countries have an institution that performs similar functions. The Federal Reserve (Fed) monitors situations related to the money supply, both in terms of deflation and inflation, and seeks to act accordingly.

However, increasing the money supply does not mean simply opening the vaults and allowing anyone in to take it. In such a situation, the problem would quickly go from deflation to inflation. Therefore, the Fed accomplishes this through interest rates. In a period of deflation, the Fed lowers interest rates, thus encouraging banks to borrow more and lend it out at lower rates.

Usually, small changes in the Fed interest rates can create major waves within the financial community. These will likely be felt both domestically and internationally. Due to this power, the Fed usually only cuts rates a fraction of a percentage point at a time and then waits to see what effect it will have before deciding on future cuts or increases. The goal is always to find an equilibrium that will help the economy and decrease volatility. In financial matters, stability is the key.

It should also be noted that not all price decreases are the result of deflation causing an economic crisis. Companies may always be looking at ways to find efficiencies in production. These efficiencies are often seen by the consumer in the form of a decline in price levels. However, efficiencies in production are usually identifiable and not easily confused by professional analysts. Often, these efficiencies may apply to one type of product or even within one certain company, not an overall economy. If more than one sector of the economy becomes affected by price declines, deflation would then be the likely culprit.