Deflation or Negative Inflation: Causes and Effects

What Is Deflation?

Deflation, or negative inflation, happens when prices fall in an economy. The supply of goods may be higher than the demand for those goods, but the buying power of money may be increasing. Buying power grows with a reduction in the money supply and a decrease in credit, which hurts consumer spending.

Causes of Deflation

Monetary deflation is caused by a decrease in the supply of money. The money supply is influenced by central banks, such as the Federal Reserve. When the supply of money and credit falls, without a corresponding decrease in economic output, then the prices of all goods tend to fall. With more goods produced than demand, businesses decrease their prices to spur buying.

Declining prices can also be caused by a decline in aggregate demand, a decrease in the total demand for goods and services, and increased productivity. Causes of this shift include reduced government spending, stock market failure, consumer desire to increase savings, and tightening monetary policies such as higher interest rates. 

Milton Friedman argued that under optimal policy, in which the central bank seeks a rate of deflation equal to the real interest rate on government bonds, the nominal rate should be zero, and the price level should fall steadily at the real rate of interest. His theory birthed the Friedman rule, a monetary policy rule.

Consequences of Deflation

Deflation can ripple through the economy, cause high unemployment, and catapult a recession into a depression. When companies are unable to sell products and revenue decreases, they cut costs. This may include closing stores, plants, and warehouses, and laying off workers. Workers will decrease spending, leading to less demand and more deflation. This deflationary spiral that is hard to break.

A deflationary spiral can occur during periods of economic crisis, such as a recession or depression, as economic output slows and demand for investment and consumption dries up. This may lead to an overall decline in asset prices as producers are forced to liquidate inventories that people no longer want to buy.

Consumers and businesses begin holding on to liquid money reserves to cushion against further financial loss. As more money is saved, less money is spent, further decreasing aggregate demand. Consumers have less incentive to spend money when they can reasonably expect that their money will have more purchasing power in the future.

The Bottom Line

Deflation is the decline in the price level of goods and services associated with a contraction in the supply of money and credit. The money supply is influenced by central banks. When the supply of money falls, without a corresponding decrease in economic output, the prices of all goods tend to fall. Deflation can cause high unemployment, recession, or depression.