What is deflation?

Deflation is a persistent decline in prices. If the price decline seen in recent months persists, it would be called deflation. However, every fall in prices is not called deflation.

How often does deflation occur?

Other than in Japan, for the years between 1999 and 2005 when consumer prices fell by an average of 0.5 per cent per year, the world has not seen serious deflation since World War Two.

How is disinflation different from deflation?

Disinflation is a fall in the inflation rate. So, what we have seen in recent months, with the inflation rate coming down from double digit levels to near zero, has clearly been disinflation. Prices do not have to fall in this situation. They merely need to rise at a slower and slower pace.

What causes deflation?

Deflation may be caused either by a shrinking of demand compared to supply, where there is an abundance of goods and so their prices decline; or it may be caused by a decline in money supply. When many industrialised countries tried to get rid of inflation and put their economies back on the gold standard after the second world war, they ended up in pushing their economies into deflation.

What are the costs of deflation?

When people see prices falling they tend to postpone consumption. If the fall in demand in comparison to supply has led to the initial fall in prices, this helps in reducing demand further and can lead to more deflation. This also encourages producers to postpone investment. The fall in demand from both investment and consumption can make deflation a self-fulfilling prophecy. If nominal wages are downwardly rigid, then we will see that real wage will be higher after deflation. This would mean that firms would not hire as much labour as they could at a lower real wage rate. Thus deflation could, in the presence of downward nominal wage rigidity, lead to higher unemployment. Firms and households who have borrowed money have to pay back greater amounts in real terms than they had contracted for if there is deflation. This is the opposite of what happens when there is inflation in which case the lenders lose and the borrowers gain. Now the opposite happens.

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