Deflation occurs when asset and consumer prices fall over time. While this may seem like a great thing for shoppers, the actual cause of widespread deflation is a long-term drop in demand.
Deflation often signals an impending recession. With a recession comes declining wages, job losses, and big hits to most investment portfolios. As a recession worsens, so does deflation.
Businesses hawk ever-lower prices in desperate attempts to get consumers to buy their products and services. Deflation is measured by a decrease in the Consumer Price Index. But the CPI does not measure stock prices, an important economic indicator.
For example, retirees use stocks to fund purchases. Businesses use them to fund growth. In other words, when the stock market drops, the CPI might be missing one important indicator of deflation as it's felt in people's pocketbooks.
Comprehensive awareness of this economic indicator is important for effectively gauging whether or not a dramatic dip in the stock market will cause a recession.
Neither does the CPI include sales prices of homes. Instead, it calculates the "monthly equivalent of owning a home," which it derives from rents. This is misleading since rental prices are likely to drop when there is a high vacancy. That's usually when interest rates are low and housing prices are rising. Conversely, when home prices are dropping due to high-interest rates, rents tend to increase. This is why asset inflation during the housing bubble of went essentially unnoticed.
Had it been a focus, the Federal Reserve could have raised interest rates in an attempt to prevent the bubble. Such a strategic response might have also mitigated some of the pain when the bubble burst in There are three reasons why deflation exists as a greater threat than inflation since First, exports from China have kept prices low.
The country has a lower standard of living, so it can pay its workers less. China also keeps its exchange rate pegged to the dollar, which keeps its exports competitive. Second, in the 21st century, technology such as computers keeps workers' productivity high. Most information can be retrieved in seconds from the internet. Workers don't have to spend time tracking it down. The switch from snail mail to email streamlined business communications.
Third, the excess of aging baby boomers allows corporations to keep wages low. Many boomers have remained in the workforce because they can't afford to retire. They are willing to accept lower wages to supplement their incomes. These lower costs mean companies haven't needed to raise prices.
Deflation slows economic growth. This cookie is used for social media sharing tracking service. Performance Performance. Performance cookies are used to understand and analyze the key performance indexes of the website which helps in delivering a better user experience for the visitors.
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This cookie is used to provide the visitor with relevant content and advertisement. This cookie is used for marketing and advertising. The cookie stores a unique ID used for identifying the return users device and to provide them with relevant ads. Throughout most of U. The CPI tracks the prices of a group of commonly purchased goods and services and publishes the changes every month.
When the prices measured in aggregate by the CPI are lower in one period than they were in the period before, the economy is experiencing deflation. Conversely, when the prices collectively rise, the economy is experiencing inflation. Deflation is not to be confused with disinflation. Though they both sound like they would indicate decreases in prices, disinflation actually signifies that prices are still rising, just more slowly than they have been.
Deflation, on the other hand, describes actual decreases in prices, not a decrease in the rate that inflation is rising. There are two big causes of deflation: a decrease in demand or growth in supply.
Each is tied back to the fundamental economic relationship between supply and demand. A decline in aggregate demand leads to a fall in the price of goods and services if supply does not change. Higher aggregate supply means that producers may have to lower their prices due to increased competition.
This boost in aggregate supply may stem from a drop in production costs: If it costs less to produce goods, companies can make more of them for the same price. This can result in more supply than demand and lower prices. Although it may seem helpful for the price of goods and services to fall, it can have very negative effects on the economy. When prices go up and the power of the dollar goes down, the economy is experiencing inflation.
Inflation is also something consumers can protect themselves against to a certain extent. Investing your money , for instance, can help your earnings grow faster than inflation, helping you retain and grow your purchasing power. While it may seem worse for prices to rise than to fall, deflation is generally less favorable and is associated with economic contractions and recessions.
A deflationary spiral may turn hard economic times into recessions and then depressions. Protecting yourself against deflation is also a little trickier than safeguarding against inflation. Unlike with inflation, debt becomes more expensive with deflation, leading people and businesses to avoid taking it on as they try to pay off the increasingly pricy debts they already owe. Overall, the United States has primarily experienced inflation, not deflation. But during some periods, deflation has shaped the economies of the U.
Deflation was an accelerator of one of the toughest U. Although it began as a recession in , rapidly decreasing demand for goods and services caused prices to drop significantly, which led to the collapse of many companies and rising rates of unemployment. Price deflation due to the Great Depression happened in virtually every other industrialized country in the world. In the U. Japan has experienced a state of mild deflation since the mids.
In fact, the Japanese CPI has been almost always slightly negative since , except for a brief period before the global financial crisis.
Surprisingly, these economists make the claim that deflation can be more positive than negative. According to these economists, good deflation occurs when the aggregate supply of goods outstrips aggregate demand. This can be the result of advances in technology or improved productivity. Bad deflation occurs when aggregate demand falls faster than any growth in aggregate supply.
Negative money shocks, like what happened during the Great Depression, create "bad" deflation. When monetary neutrality is maintained despite negative money shocks, the impact of deflation can be neutral. They concluded that the link is statistically weak or insignificant, and the prevalence of this theory in economics is a result of the events of the Great Depression. In some contexts, deflation can inhibit strong, sustainable economic growth. But like the economists at NBER, these researchers make the claim that deflation is not always a sign of an aggregate demand shortfall and economic weakness.
In some cases, deflation can be the result of increased supply from improvements in productivity, greater competition in the goods market, or cheaper and more abundant inputs, such as labor or goods like oil. When deflation is driven by supply, prices are depressed but incomes and output as in GDP increases. This can create a positive situation for the economy.
BIS's research goes on to reveal that asset price deflations and housing price deflations have been more damaging to the economy than a rise in the price of consumer goods and services. The best way to respond to deflation when it does present an economic loss is a challenging policy question that economists are still trying to answer. However, the view that deflation is always a symptom of a struggling economy may not be true, though it is deep-seated in economic theory.
This belief is primarily the result of studying the Great Depression, which cannot be considered the archetypal example of what happens during persistent deflationary periods. Rather, according to economists, this period in economic history can be viewed as an outlier. National Bureau of Economic Research. Swiss National Bank. Accessed June 18, CIA World Factbook.
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