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What is Deflation?

Definition: Deflation is a decrease the prices of goods and services, thereby increasing the purchasing power of consumers and domestic currency. However, deflation can cause lower profits for firms, thereby increasing unemployment.

What Does Deflation Mean?

What is the definition of deflation? The government aims to maintain price level stability by infusing money in the market to counterbalance the impact of deflation. However, low consumer spending due to lower money supply decreases demand; therefore, the supply of goods outpaces demand, causing depression in the economy.

Furthermore, due to lower demand, unemployment tends to rise, as firms have to lay off workers. Other causes of deflation are the innovation that causes a sharp increase in productivity, thereby leading to lower prices and a change in the capital structure of markets that facilitates firm to raise capital to fund innovative production processes.

Letís look at an example.

Example

An example of deflation is the Great Depression in the United States that followed the US stock market crash in 1929. During the Great Depression, unemployment reached 25%, and although the output of high production industries such as mining and farming was high, workers were not compensated according to their labor. Therefore, consumer spending was extremely low, and people could not afford basic goods, no matter how low the prices were.

Put simply, the circle of deflation is the following: lower prices for goods and services lead to lower profits for the firms. Firms have to lay off workers, thereby increasing unemployment. Higher unemployment leads to lower consumer spending; therefore, supply outpaces demand, and the firms lower their prices to attract consumers.

It is important to recognize deflationary pressures in an economy. Prolonged periods of declining prices can destroy an economy by launching a never-ending spiral of unemployment, lower consumer spending, and lower profits for the firms. To that end, central banks and the government monitor the economic measures that may indicate the beginning of a deflationary period.

Summary Definition

Define Deflation: Deflation is the appreciation of a currency allowing it to purchase more goods and services for a lower price.

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