What is deflation? What are it's impacts?

Economy and Finance

What is deflation? What are it's impacts?

27 Aug 2023 Zinkpot 148

Deflation is the decrease of asset prices or the prices of goods and services.
Also known as a negative inflation rate, deflation occurs when prices fall. As prices deflate purchasing power increases, meaning consumers can use the same amount of money to purchase a larger amount of goods and services.
There are mainly three causes of deflation which are tied to supply and demand:
Aggregate demand increase: One of the main causes of deflation is a drop in demand within an economy. Lower economic activity is sometimes connected to a change in monetary policy, such as higher interest rates or lower government spending.
Aggregate supply increase: When there is an excess in the supply of goods, companies must lower prices to offset the surplus of material.
Decrease in the supply of money: Another cause for deflation is a decrease in the amount of money circulating in an economy.
Deflation can have several negative effects on an economy:
High unemployment rates: Many firms will attempt to offset production costs and falling prices may lower wages and layoff employees.
Slower economic activity: As more people lose their jobs during deflation, consumer spending drops and causes a slowdown in economic growth.
Debt: Deflating prices of assets causes lenders to refrain from giving borrowers or debtors new loans. This causes an increase in the real value of debt. In an attempt to encourage more economic activity, central banks might lower interest rates.
Stock market drop: During deflationary periods, stock markets often crash as investors pull out because of increased volatility and a lack of returns.
Deflationary Spiral: It is a vicious cycle where deflation leads to further stagnation of the economy that reduces the production of companies and consumption causing more deflation in a spiral form, which is difficult to get out.
Deflationary Spiral is caused because the drop in prices reduces the profits of the companies and this causes a decrease in production. The drop in production causes lower income in the population (and even layoffs), which in turn leads to a further drop in consumption (decreased demand), again creating an excess supply of goods and services that requires new entrepreneurs to lower prices, exacerbating deflation.