Definition of Deflation

By: EconomyWatch   Date: 14 October 2010

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Deflation is characterized by a fall in the general price level over a specific time period. As an economic concept just opposite to Inflation, Deflation at times denotes a reduction in the size of money supply, from the economic viewpoint. It is this condition which is commonly known as the 'Contraction' of the money supply. Moreover, when Deflation affects the economy of a country, the demand for liquidity rises, followed by escalation in the purchasing power of money as well. In a modern economic condition, Deflation is considered a matter of deep and serious concern, due to a possible rise in deflationary spiral.


Why Deflation occurs?
  • At a condition where there is enough competition, Capitalism also acts as the driving force behind Deflation. Development of capital stocks furthers the competition, leading to increase in the supply of goods. Under this circumstance, the prices automatically reduce till they stabilize the demand. Capitalism initiates innovation and efficiency, whereby the prices go down, leading to Deflation.

  • From the monetary point of view, Deflation results from a decrease in the velocity of money an/or the amount of money supplied per person.

Impacts exerted by Deflation:
  • Nominal prices tend to be a bit sticky in nature, owing to certain organizational factors. Hence, monetary deflation results in extensive liquidation.

Theories regarding Deflation:
  • Neo-classical theory: Neo-classical theorists say that there is zero chance of deflation in a theoretically ideal competitive market, as the control of money will be under the monetary authorities and prices will be permitted to oscillate.

  • Keynesian concept: According to the Keynesians, deflation occurs when there is increase or fall in the wages at various rates, than that of productivity. When wages do not increase at the productivity rate for prolonged time period, it causes Deflation.

  • Austrian School: Followers of the Austrian School of Thought hold Deflation responsible for a general reduction in the prices, and do not consider it to be a general price fall itself. To them, Deflation is a contraction of money supply. Deflation in the world:

  • United States of America: As far as the United States of America is concerned, it underwent two significant eras of deflation, one immediately after the Civil War, commonly known as The Great Deflation. At this time, Deflation resulted out of the intentional and premeditated policy of outdating the paper notes printed during the Civil War. The other one occurred between 1930-1933, when the deflation rate was around 10% annually. Deflation in this period followed from the Civil War, and was a part of the nation's slide into the Great Depression. This was followed by failure of the banks and increase in the unemployment rates to about 25%.

  • British Isles: Among principal nations of the world undergoing Deflation, mention must be made of the British Isles. Deflationary trend started in United Kingdom in the post-First World War period when the pound reverted back to the gold standard, on the basis of the pre-War price of gold. Since this price was higher than the equivalent gold price, it required deflation to occur, in order to realign it with pound's high target value.

  • A handful of South-East Asian countries like Japan and Hong Kong are also known to have experienced Deflation to a certain extent.


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