What is Deflation?

What is Deflation
Deflation can be defined as a constant decline in the general price of goods and services. In case of deflation, which exhibits the opposite pricing behavior of inflation, goods and services in the market tend to become cheaper. Deflation occurs when the inflation rate falls below 0%. In this article, you can find answers to the questions what is deflation, what are its causes and consequences, and what are the differences between deflation and inflation.

What is Deflation?

Deflation, which can also be defined as negative inflation, is used to describe the ongoing downward trend in general price levels. In deflationary economies, the prices of goods and services become cheaper, and in parallel, the purchasing power of the currency increases, but production tends to decrease over time.

To put it in more detail, consumer habits change in the face of constantly decreasing price levels. Consumers tend to postpone their spending, expecting that the decline in price levels will continue. Therefore, even if prices become cheaper, consumption, that is, demand, decreases. As a result of the supply remaining high compared to demand, producers continue to reduce prices in order to find buyers. In this case, producers' income decreases and they have difficulty covering their costs. At this point, unemployment in the overall economy begins to increase, investments decrease and economic activity shrinks.

Deflation, disinflation and inflation, which represent different behaviors in price levels; It is measured using the consumer price index (CPI), producer price index (PPI) and gross domestic product deflator. The consumer price index (CPI) measures price changes in a basket of consumer goods. Producer price index (PPI) measures the prices of produced goods and services at the producer level. The gross domestic product deflator is an inflation indicator that measures broader economic activity.

However, deflation and disinflation are two terms that are confused with each other. Disinflation is used when the rate of increase in inflation slows down. In a disinflationary environment, general price levels continue to rise more slowly than in previous periods. In simple terms, as the rate of inflation decreases, prices are still rising, but at a slower rate. Deflation means the actual decline in the general price level. In other words, it is negative inflation.
What are the Causes of Deflation?

The main causes of deflation include lack of demand, that is, a decrease in the tendency to consume, an increase in supply, that is, excess production, and monetary and fiscal tightening.

Periods when the money supply is higher than the output in the economy causes inflation. After a period of monetary expansion, monetary and fiscal tightening may be implemented to combat inflation. Increasing interest rates by central banks, reducing government expenditures and increasing taxes on the fiscal side are factors that reduce the money supply in the economy.

In the period when the money supply decreases and the general production level remains constant, the general price level of goods and services tends to decrease. Rising interest rates as a result of the falling money supply may cause individuals to save more and borrow less. In other words, consumption, that is, demand, may exhibit a downward trend. However, global epidemics, etc., which may affect expectations or suddenly increase the tendency to save. Factors that reduce confidence in the economy, such as developments and unemployment concerns, can also reduce consumption. In summary, when supply remains constant but demand declines, prices of goods and services decrease and may result in deflation.

On the other hand, deflation may also occur in periods when the supply of products and services increases faster than the money supply. Technologies that can increase production and reduce costs increase economic output. If supply exceeds demand, deflation may occur due to both increased competition between producers and decreased production costs. Technology-induced deflation is healthy for economic growth. As a result, the consumer's purchasing power will increase over time, providing access to better quality goods and services, and the producer will increase their income over time.

What are the Consequences of Deflation?

In the period when the money supply decreases and the general production level remains constant, the general price level of goods and services tends to decrease. Rising interest rates as a result of the falling money supply may cause individuals to save more and borrow less. Declining prices of goods and services may have a positive effect in terms of increasing purchasing power in the short term and also causing high savings. However, consumer habits may change in the face of constantly decreasing price levels over time. Consumers may tend to postpone their spending, expecting that the decline in price levels will continue.

As a result of the supply remaining high compared to demand, producers continue to reduce prices in order to find buyers. In this case, producers' income decreases and they have difficulty covering their costs. As a result of falling income, companies may reduce their production, reduce wages and lay off workers. A deflationary environment that starts with price decline and extends to unemployment can result in economic contraction.

In a deflationary environment, debts increase in real terms (real value). This means that individuals and companies may experience difficulties in paying their debts. The tendency to borrow will slow down. On the other hand, in a deflationary environment, asset prices may decline and financial stability may decrease. This encourages less investment. Capital market instruments, real estate, etc. While the value of investments declines, the relative value of holding cash may increase. However, deflation increases the value of the currency, causing current account deficit and foreign trade deficit.

To prevent deflation, expansionary monetary and fiscal policies are implemented to stimulate consumption. However, another way to prevent deflation is to reduce the cost of producing goods and services by easing taxes or regulations on businesses.
What are the Differences Between Deflation and Inflation?

Inflation and deflation (negative inflation) represent opposite behavior in price levels. If the money supply in any economy moves above the total level of goods and services produced, inflation occurs. On the other hand, if the money supply in the economy is below the total level of goods and services produced, deflation may occur.

Inflation refers to the increase in the general price level of goods and services and the corresponding decrease in the purchasing power of money. Deflation refers to the decrease in the general price level of goods and services and the parallel increase in purchasing power.

Except when the money supply in the economy moves above the total level of goods and services produced; When the demand for limited goods and services increases or production costs increase, prices may tend to rise, that is, inflation may occur.

Except when the money supply in the economy moves below the total level of goods and services produced; When demand for goods and services decreases or production costs decrease and competition increases, prices may tend to fall, that is, deflation may occur.

In an inflationary environment, consumers tend to bring forward their spending because they expect prices to rise in the future. In a deflationary environment, consumers tend to postpone their spending, expecting that the decline in price levels will continue. Debt decreases.

In an inflationary environment, the real value of debt decreases. The relative value of holding cash decreases and asset prices increase. On the other hand, in a deflationary environment, the real debt increases. The relative value of holding cash increases, asset prices may fall.

In the economics and finance literature, it is accepted that fighting inflation is easier (under certain conditions). To combat inflation, monetary tightening is implemented and the money supply in the economy is reduced. To combat deflation, monetary expansion is carried out. However, monetary expansion may not be enough to change consumer habits. Therefore, different applications may need to be implemented.