What Is Deflation?

Definition and Causes of Deflation 

First Published: ADawnJournal.com April 3, 2010

Deflation is the opposite of inflation, and that naturally means that it is a good thing for the economy. Deflation represents a decrease in the price level of goods and services. It happens when inflation falls below zero percent, which causes an increase in the value of money, which allows you to buy more goods with the small amount of money.

While deflation can be good because we can buy more things with the same amount of money, but deflation is not always a good thing. In fact, deflation is linked with recessions and even the Great Depression. Deflation also prevents a government from being able to stabilize its economy. This doesn’t mean that deflation is only about poor economic times though.

What Causes It?

Deflation is caused when the supply and demand of goods goes up, and the supply and demand of money, goes down. So, when there is an increase in production on goods and services, it causes there to be a greater supply of goods, without increasing the supply of money to buy those goods. When the money supply goes down, typically the demand for goods goes down as well. This doesn’t happen with deflation. A rise in production, with a lack of supply in money, creates that unique combination for deflation.

Types of Deflation

There are four different types of deflation that can happen.

1.   Cash Building Deflation: This is caused when people are saving more money, which decreases the use of money but increases the demand for money.

2.   Growth Deflation: This is when there is a decrease in the Consumer Price Index and an increase in the supply of goods.

3.   Bank Credit Deflation: This is when there is a decrease in the credit supply of the bank, caused by bankruptcies, and a contraction of the money supply from a nation’s central bank.

4.   Confiscatory Deflation: This is the freezing of bank deposits and a decrease of the money supply.

Times of Deflation

In modern times, there have been several instances of deflation in several industrialized countries. Some examples include:

·   During the First World War, the British Pound was removed from the gold standard to finance the war. This caused a rise in gold prices and rapid inflation, while decreasing the exchange rate of the pound. When the pound was retuned as the gold standard when the war ended, it was done so at the pre-war gold price, which caused prices to fall.

·   In the United States, there have been three times of major deflation. The first was in 1836 when the currency of the country contracted by one-third. The second was during the Civil War, which was caused by the retiring of paper money during the Civil War, as well as the return of the gold standard. The third was between 1930 and 1933 when the deflation rate was 10 percent per year because so many banks were failing. There may be a fourth deflation crisis going on right now according to some economists, but only time will tell if they are right.