Deflation refers to a sustained decline in the price level of goods and services. It occurs when the annual inflation rate
falls below zero percent (a negative inflation rate), resulting in an increase in the real value of money. The vicious cycle of
declining demand and rising unemployment often leads to an economic depression.
Causes of Deflation
Deflation in an economy can be attributed to more than one factor, including:
When the risk adjusted return on assets becomes negative, buyers and investors start to hoard currency instead of investing it.
Sustained decline in the velocity of money or a decline in the number of money transactions.
Higher interest rates initiated by the country’s central bank to control inflation.
Effect of Deflation on the Economy
A fall in the price of goods and services increases the purchasing power of the people. This might present a positive picture
in the short run. However, if this effect extends, it leads to deflation, adversely impacting the economy. With deflation, prices and wages begin to fall. Consequently, the supply of money shrinks, resulting in even lower prices and wages. This creates a vicious 'deflationary spiral' of negatives, including declining profits, closing factories, shrinking incomes and employment and a rise in defaults on loans by individuals and companies. Deflation creates a liquidity trap in the economy when lower interest
rates fail to stimulate spending. Deflation usually occurs during recessionary times and tends to aggravate its negative
effects.
Inflation vs Deflation
Inflation is the opposite of deflation and refers to a rise in the general level of the prices of goods and services.
Deflation is considered as negative inflation because it increases the real value in money, whereas inflation has the reverse effect. Deflation causes a burden on borrowers and holders of various illiquid assets and is favorable for savers and holders of liquid assets
and currency. On the other hand, inflation favors short-term consumption and borrowers and is a burden on
currency holders and savers.
Both inflation and deflation can negatively impact the economy. However, most economists consider the effects
of moderate long-term inflation to be less damaging than deflation.