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Deflation Explained

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We hear an awful lot about inflation, especially during tough economic times, but what about deflation. The concept of deflation might be foreign to most of us because we hear of it so rarely. Truth be told, deflation is just the opposite of inflation. It can be equally damaging to an economy.

Where inflation is characterized by a sustained increase in consumer prices, deflation is an extended decrease of those prices. We are talking about the prices of things you and I buy everyday such as gasoline, food, consumer electronics, clothing, etc. It also applies to durable goods and utilities as well. When prices drop and remain lower for an extended amount of time, we are considered to be in a deflationary period.

Deflation is rare due to the way the U.S. money supply is managed by the Federal Research. When it does occur, it is usually the result of a prolonged recession or an economic depression. It is also usually the result of supply and demand issues that persist despite the Federal Reserve’s most aggressive monetary policies.

Why is deflation bad? Prolonged deflation is bad because the drop in consumer prices makes it more difficult for businesses to be profitable. Falling profits mean less productivity, business closings, job losses and the like. In simple terms, businesses will not continue operating if they cannot make a reasonable profit. Every company that closes adds to the cumulative negative effect on the economy.

To combat sustained deflation the government will restrict the amount of cash in the system, thereby increasing its value and, at the same time, encouraging inflation. In this sense, one could argue that inflation is good. Tightening the money supply increases prices and profits, encouraging businesses to grow and expand.

A difficult task for the Federal Reserve and the Department of Commerce is to manage both monetary policy and the money supply in order to find the right balance. Both deflation and inflation can be good or bad scenarios if not managed properly.

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Meet the Author

Anthony Carter currently resides in Fife, Scotland with his wife Lisa, and their three wonderful children. As a senior editor for various publications, if he's not reading and writing, you would find him photographing and traveling to some of the most far-flung locations around the world.

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