Deflation is a general decline in the price of goods and services in the economy. It occurs when there is a contraction in the supply of money in the economy and can have a large economic impact across many different sectors. To get a better understanding of deflation it’s important to have a historical and modern perspective. As such it’s important to know the general causes of deflation along with some examples of deflation to gain a proper understanding.
- Deflation is caused by a decrease in the money supply or financial assets redeemable via money
- Deflation can cause the slowing of economic expansion and supply shocks that are harmful to the economy as a whole
Main Causes of Deflation
By definition deflation is caused by a general decrease in the money supply or financial assets that are redeemable via money. The money supply is influenced by central banks like the Federal Reserve. When the money supply decrease without a decrease in economic output, the price of goods and services will naturally fall.
Deflationary periods usually begin after sustained periods of financial expansion. This can happen if interest rates are kept very low for a sustain period of time. When interest rates are held low for a sustained period of time it can cause rising rates of inflation. Rising rates of inflation are battled by the Federal Reserve with an increase in the fed funds rate and the cycle goes on and on.
Recommended Reading: Inflation vs. Deflation – Differences and Economic Implications
However, if a countries monetary policy is not properly managed inflation and the general state of the economy can deteriorate. To better understand deflation, it’s important to be aware of the different causes that contribute to it. There are six major causes of deflation:
- Reduced Consumer Demand
- Increased Competition
- Higher Productivity Levels
- Advancements in Technology
- Supply Shocks in Commodities
- Reduction in the Money Supply
These causes carry their own unique weight. They can be positive and negative for the economy depending on the conditions under which they occur.
For example, as the production of electric vehicles increases, it will naturally push the price of oil down making. However, the supply of electric vehicles may not be able to meet the growing demand, and as such, the cost of electric vehicles is much higher for the average consumer. Let’s take a look at examples of deflation from a historical perspective along with some examples in our modern worldview.
Deflation Examples In History
The Great Depression [ 1929 ]
The Great Depression of 1929 continued into the 1930’s was one of the most popular historical examples of deflation. During the Great Depression there was a significant drop in demand and supply which led to a collapse in prices for many companies in the United States.
This in turn led to a significant drop in the stock market as well as a general collapse in the banking system. This Great Depression lasted approximately a decade and it wasn’t until 1942 that America began to see some economic recovery.
The Japan Deflation [The Lost Decade]
Between 1991 and 2001 the Japanese economy went through a long deflationary period known as the “Lost Decade“. Prior to that Japan’s economy was considered one of the strongest and robust economies in the world. The country was going through a massive economic expansion
Before that Japan’s economy was considered one of the most robust economies in the world. The country was going through a massive economic expansion from the early 1970’s to 1990. Following this massive economic boom, Japan experienced a heavy dose of economic reality for the next decade.
The main culprit behind their economic deflation was rising interest rates. Rising interest rates quickly created a liquidity crisis in their credit markets as investors held onto their cash reserves instead of actively investing them. This is because investors could get better returns on their money instead of investing in developments. Japan was eventually able to turn its economy around but it was a painful process that last a decade.
Economic Crisis of 2008 [ Housing Bubble ]
The 2008 financial crisis is perhaps one of the most aggressive examples of deflation. This is mainly because it was a manufactured crisis due to poor lending practices that spiraled out of control. Lenders were giving out mortgages to people who couldn’t afford them and had poor approval requirements for people to qualify for mortgages.
Predatory lending practices led to aggressive risk-taking by mortgage companies that eventually led to a widespread housing crisis across the United States. This caused a ripple in the financial system that had a massive global impact and forced the Federal government to bail out many banks and lending institutions. Although the crisis was generally short-lived due to the government bailout, its effects still thump throughout the economy.
Deflation Example In Modern Times
A lesser discussed type of modern deflation is one in the cryptocurrency markets. The cryptocurrency market regularly goes through periods of massive price inflation and periods of massive price deflation.
This is partly because the cryptocurrency market is still in its infancy and blockchain technology hasn’t seen massive widespread adoption. As the cryptocurrency market matures the periods of price inflation and deflation will normalize and have more consistent price behavior.
Strategic Deflation [ High Inflation ]
Strategic deflation occurs due to specific policies created by the federal government and banks to shift interest rates to control rising rates of inflation. This is currently an ongoing process by the Federal Reserve to try and get inflation under control in the United States.
With the current inflation rate at 9.4% in the United States in 2022, the Federal Reserve has been increasing the fed funds rate to battle the effects of inflation. The high inflation rate environment was created by them holding interest rates at a very low rate for an extended period of time.
Effects of Deflation on the Economy
Deflation can have positive as well as negative effects on the general state of the economy. If deflation is caused due to improvements in technology, increased competition, and efficiency it can have an overall positive impact on society and the economy. It can cut out cumbersome labor through automation and make products and services more affordable for consumers.
However, deflation is generally perceived as a sign of a weakening economy. It causes more of an incentive for people to save their money and delay spending because prices will be lower in the future and consumers’ purchasing power will increase. This type of behavior by consumers and investors slows down the economy and causes it to contract.
Can The Government Control Deflation?
The government can battle the effects of deflation in a few different ways. One of the most popular ways is by controlling interest rates. Another popular and more modern approach is quantitative easing. However, it’s worth noting that if the government attempts to control the natural behavior of the economy for a long period, it can harm the economy.