What Is Deflation?

Simply put, deflation is the overall reduction of the level of prices for goods and services in any economy. That is, something that costs $200 in a healthy economy costs only $180 in a seriously deflated economy. But this definition does not encompass everything about deflation, including its consequences.

Definition

In the MIT Dictionary of Modern Economics, deflation is defined as "a sustained fall in the general price level". This means that the overall prices of everything, from gasoline and petroleum products to corn and food products, are lower than they were before the economy was deflated. This concept is not all encompassing: not EVERYTHING in a deflated economy has to be lower as long as the general price trend is downward.

The price level is measured using a few indicators: the Gross Domestic Product Deflator, or GDP Deflator, or the Consumer Price Index, or CPI. The former is an overall index of inflation (inflation is the opposite of deflation, when prices are generally higher); the latter is an index of the prices of several generally consumer products. The United States Department of Labor manages the official CPI on its Bureau of Labor Statistics website.

Consequences

Deflation can cause serious problems in a modern economy. In fact, deflation is, at the beginning of the second decade of the 21st century, the biggest concern for the global economy. While deflation generally means lower prices for consumers, which may seem like a good thing, it generally indicates a period of economic downturn and unemployment. Economist and New York Times columnist Paul Krugman identifies three major reasons why individuals and countries should worry about deflation.

Firstly, according to Krugman, consumers are less likely to spend money during a deflation. Once consumers expect lower prices, they're less willing to pay higher prices and even less willing to borrow money. In a deflated economy, dollars are essentially worth less than they were in a healthier economy, so a dollar borrowed in a deflated economy will have to be repaid with a dollar that is worth significantly more when the economy starts to recover.

Next, Krugman warns that a deflation increases the financial burden on debtors. Falling prices increase the real burden of consumers' debts. While debtors cut their spending in a deflated economy, creditors do not raise their spending, which, effectively, results in less money circulating in the economy, which aggravates a deflation cycle.

Finally, Krugman points out that prices aren't the only things to fall during a deflation: wages, too, fall. And because of what's called "downward nominal wage rigidity," a deflation leads to high unemployment. And unemployed consumers are much less likely to do any spending than employed consumers.

These consequences don't kick in when the economy is only marginally deflated; they start to become apparent, however, when a deflation is severe or prolonged.

Combating Deflation

Prolonged deflation is a nightmare for economies because it's more difficult to combat than inflation. When facing inflation, governments and banks can raise interest rates, which is an almost limitless solution; to combat deflation, however, interest rates must be lowered, and there's a limit to how low they can go. If you lower interest rates to nothing and consumers still won't borrow, there's little else that you can do to motivate them.

Deflation in History

The most memorable example of deflation began in 1929: the Great Depression. The 1920s--called the Roaring Twenties--experienced a rise in mass production and mass consumption. Consumers were borrowing large sums of money with no real method for repayment. Eventually, available credit was exhausted and consumers quit spending. Then the stock market crashed in 1929. Banks' cash reserves were quickly exhausted. As the economy spiraled downward, unemployment rose to around 25 percent. What was particularly damaging about the Great Depression was that it lasted for nearly a decade: such a long period of deflation has serious sustained and global consequences.

In the early 1990s, Japan experienced a similar period of sustained deflation. Japan experience a boom during the 1980s, not totally unlike that in the U.S. in the 1920s; when its bubble burst, as bubbles inevitably do, the result was a prolonged deflation. In 1998, Paul Krugman argued that Japan's monetary policy during its depressed economy resulted because interest rates could not be pushed below zero percent.