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What is deflation?

Deflation is the decrease in the general price level for goods and services. It happens when the inflation rate falls below 0%.

When there’s deflation in an economy, the value of money increase because people can spend less to buy different products.

Deflation is the opposite of Inflation.

Understanding deflation

Changes in the prices of goods and services is usually measured by the Office for National Statistics (ONS) in the UK. They’ll compare a diverse range of goods and products to measure changes in prices over the past 12 months using The Consumer Prices Index (CPI).

When the index is lower, compared to the previous year, it means the general level of prices has declined, an indication the economy is experiencing a period of deflation.

What causes deflation?

    Deflation usually happens when there’s a high supply of different products, but when It can be caused from a number of different factors:

  • A drop in the money supply – central banks, like the Bank of England (BoE) in the UK, could use tighter monetary policy by increasing interest rates. If interest rates are higher, instead of spending money straight away, people might prefer to save it. An increase in interest rates also means it's more expensive to borrow money, so people are less likely to borrow. This in turn discourages people from spending into the economy.
  • Loss of confidence – if something negative happens in the economy, like a recession, people might become nervous about the future. This could cause people to spend less.
  • An increase in supply – if there’s an increase in the total supply of goods and services available from product producers, this can also cause deflation. It could mean producers have to face more competition from other suppliers.
  • An increase in supply can be caused by:

  • Lower production costs – when production costs are lower, producers of those products can increase their supply. This can turn into an oversupply of goods in that economy. If the demand for the products doesn’t change, producers would need to lower the prices of their goods for people to continue buying them.
  • Advances to technology – when a producer is able to implement new technology during its production process, it's likely to make production quicker and cheaper. This should therefore make the prices of their products go down.

Is deflation good or bad?

A small amount of deflation might not seem like such a bad thing. For consumers, if the price of goods and services goes down, it increases the purchasing power of money.

Generally, deflation in an economy isn’t seen as a good thing. If an economy is going through a deflationary period, it could turn into a recession and later into something much worse like a depression. Remember though, the past isn’t always a guide to the future.

Some of the negatives of deflation can include:

  • Increased unemployment – during a period of deflation, unemployment rates can rise. Because the price of goods and services are decreasing, producers will cut their costs by laying off employees.
  • An increase in the real value of debt – because deflation is linked with an increase in interest rates, it’s also linked with an increase in the real value of debt. This means consumers are less likely to borrow money and will wait before they spend.
  • A deflationary spiral – this usually happens during times of crisis in an economy, like a recession or depression. Because of the lower price levels, it triggers a chain reaction leading to lower production, wages and a decrease in demand. This then leads to even lower prices.