Deflation

Reviewed by Annapoorna | Updated on Aug 27, 2020

What is Deflation?

In Economics, deflation refers to a general decline in the prices of goods and services. It is typically associated with a diminution in the supply of money as well as credit in the economy. During deflation, the purchasing power of the country's currency rises over time.

Even though deflation is associated with a contraction in the supply of money and credit, still the prices can also drop due to improved productivity and technological developments. The like towards various investment options keep changing whether the price level, money supply, and economy are deflating or inflating.

Causes of Deflation

A fall in the supply of money or cash equivalent redeemable financial instruments can cause a monetary deflation. In recent times, the supply of money is mostly regulated by the central bank, such as the Reserve Bank of India (RBI).

A drop in both money and credit in the economy without a relative fall in economic output may still see the prices of all goods diminish. Periods of deflation most commonly occur after long periods of artificial monetary expansion.

Effects of Deflation

Deflation leads to the nominal costs of labour, goods, services, and capital to fall, despite their relative prices being left unchanged. Deflation has been a popular issue among economists for several years.

At the first look, deflation seems to benefit consumers because they can buy more goods and services using the same nominal income for a period.

But not everyone profits from lower prices and economists are often concerned about the after-effects of falling prices in the financial sectors, including several other sectors of the economy.

In particular, deflation can badly hit the borrowers, who could become liable to repay their debts at a higher value than the value of loan borrowed. Further, it's negative impact could be felt by the financial market participants who speculate or invest on the prospect of increasing prices.

Conclusion

To correct the negative impact of deflation, usually central banks adjust the monetary policy to promote a consistent increase in the money supply in the economy. It may lead to a situation of chronic price inflation but would eventually encourage debtors to borrow more, serving the purpose.