Why deflation is not harmful

Find me at kateashford. John Schmidt is the Assistant Assigning Editor for investing and retirement. Before joining Forbes Advisor, John was a senior writer at Acorns and editor at market research group Corporate Insight. Select Region. United States. United Kingdom. Kate Ashford, John Schmidt. Contributor, Editor. Editorial Note: Forbes Advisor may earn a commission on sales made from partner links on this page, but that doesn't affect our editors' opinions or evaluations. Deflation Definition Deflation is when consumer and asset prices decrease over time, and purchasing power increases.

How Is Deflation Measured? Deflation vs. Disinflation Deflation is not to be confused with disinflation. What Causes Deflation? A drop in aggregate demand may be triggered by: Monetary policy: Rising interest rates may lead people to save their cash instead of spending it and may discourage borrowing.

Less spending means less demand for goods and services. Declining confidence: Adverse economic events—such as a global pandemic—may lead to a decrease in overall demand. If people are worried about the economy or unemployment, they may spend less so they can save more. Consequences of Deflation Although it may seem helpful for the price of goods and services to fall, it can have very negative effects on the economy. As prices drop, company profits decrease, and some companies may cut costs by laying off workers.

Interest rates tend to go up in periods of deflation, which makes debt more expensive. Consumers and businesses often decrease spending as a result. Deflationary spiral. This is a domino effect caused by each overlapping piece of deflation. Falling prices may result in less production.

Less production may lead to lower pay. Lower pay may result in a drop in demand. And a drop in demand may cause increasingly lower prices. And on and on. This can make a bad economic situation worse. Why Deflation Is More Harmful Than Inflation When prices go up and the power of the dollar goes down, the economy is experiencing inflation. Controlling Deflation The government has a few strategies to rein in deflation.

Boost the money supply. The Federal Reserve can buy back treasury securities to increase the supply of money. With a greater supply, each dollar is less valuable, encouraging people to spend money and raising prices. Make borrowing easier. The Fed might ask banks to boost the amount of credit available or lower interest rates so people can borrow more.

If the Fed lowers the reserve rate, which is the amount of cash commercial banks must have on hand, banks can loan out more money. This encourages spending and helps raise prices. Yes, one way that central bank magic works is that the Federal Reserve and the European Central Bank cut inflation-adjusted interest rates below zero when times are bad, hoping to spur borrowing, spending and investment.

At no inflation, a zero interest rate is, well, zero. And with deflation, a zero interest rate is a positive real rate. Deflation just makes all this harder to do. Once upon a time, the U. There are still some people fretting that, given all the money the Fed has pumped into the economy in quantitative easing, inflation is just around the corner. But today, the bigger fear—especially in Europe—is just the opposite. So why worry? Here are five reasons: 1.

Related Books. However, for a period of approximately five years, prices of consumer goods went down in Switzerland without any widespread negative impact on the country's economy. This has caused some economists to revise their opinion about the ill effects of deflation, with some arguing that as long as there isn't too much deflation, consumers, and producers in an economy can find an equilibrium.

In early , Switzerland's central bank introduced negative interest rates in an attempt to curb investor demand for the country's overvalued currency. In the aftermath, economists expected the Swiss economy to go into a recessionary tailspin.

On the contrary, the economy grew and the country posted a low unemployment rate of 3. Typically, when a country is experiencing a deflationary period, prices fall as a result of less consumer demand.

Lower consumer demand leads to an increase in unemployment. In addition, the ratio of public debt to gross domestic product GDP increases as the government is forced to spend more money on social welfare programs.

Deflation can push an economy into a recession. However, this was not the case in Switzerland. Although the general consensus is that deflation is bad for a country's economy, economic research is divided on the issue. 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.