Deflation, what is it?
In common usage deflation is generally considered to be "falling prices". But there is much more
to it than that. Often people confuse deflation with disinflation or with Depression (as in "the
Great Depression"). These three terms are related but not synonymous.
According to Investorwords.com the definition of Deflation is "a decline in general price
levels, often caused by a reduction in the supply of money or credit. Deflation can also be
brought about by direct contractions in spending, either in the form of a reduction in
government spending, personal spending or investment spending. Deflation has often had the
side effect of increasing unemployment in an economy, since the process often leads to a lower
level of demand in the economy. The opposite of inflation."
WHAT CAUSES DEFLATION?
Although everything said above is true it doesn't present the true nature of deflation. It tries to
define it by presenting several possible causes. For a true understanding of both Inflation and
Deflation we need to understand Supply and Demand. Just like every other commodity there is a
supply of and a demand for "Money".
In this article I am not going to address the issues of what true money is, for the sake of this
article we will assume money is simply something other people are willing to accept in exchange
for goods or services.
Price levels are the direct result of the relationship between the supply and the demand for any
given item. But the value of the money used to pay for those items is also subject to the same
relationship.
For the sake of simplicity let's assume that we are on an island and there are ten equally desirable
goods in our universe and ten $1.00 bills available to purchase them with. We can safely assume
that each item will end up costing $1.00 each.
If the quantity of money increases to $20 (without increasing the quantity of goods) the price of
the goods will increase to $2.00 - that is inflation.
If, however, the quantity of money decreases to $5.00 the price will fall to 50¢ (deflation). This is
what the first part of the above definition is referring to. The money supply can also be reduced if
someone on our island hoards half of it and refuses to spend it on anything no matter what. This
is the second part of the definition (reduction in spending).
So far we have only looked at part of the equation, the supply of money. But what happens if the
quantity of goods available increases? What if instead of having ten items we build ten more? We
now have twenty items and only $10. 00 so once again each item is worth 50¢.
This form of deflation is the good type. Everyone assumes that deflation is bad because the last
major deflation that we had was during the "Great Depression" so deflation and Depression are
synonymous in many peoples minds. In actuality if prices go down because the goods can be
manufactured more cheaply this ends up increasing everyone's wealth.
This is exactly what happened in the late 1990s, with cheap productivity available from former
Communist countries the quantity of goods is increased while the money supply increased at a
slower rate.