Deflation
Deflation is a decrease in the general price levels of goods and services. It occurs when the inflation rate falls below 0%. When this happens, the nominal prices of goods are falling on average and the purchasing power of money is increasing.
Effects of Deflation
While there are some problems associated with high levels of inflation, economists generally believe that deflation is a more serious problem because it increases the real value of debt and may worsen recessions.
Suppose you are a borrower that has borrowed $100 at a 5% interest rate to pay back in one year. Next year, you will give your lender $105 regardless of inflation. If there is no inflation, $105 next year buys the same amount as it does today. If there is inflation, $105 next year buys less than $105 does today. And if there is deflation, $105 next year buys more than $105 does today.
Deflation is good for lenders and bad for borrowers: when loans are paid back, the cash is worth more. Thus, deflation discourages borrowing, and by extension, consumption and investment today.
What Causes Deflation?
There are several theories about the causes of deflation. In the IS/LM model, deflation is caused by a shift in the supply and demand curve for goods and services. If there is a fall in how much the whole economy is willing to buy, for example, then the general demand curve shifts to the left and overall prices fall. Because the price of goods is falling, consumers have an incentive to delay purchases and consumption until prices fall further, which in turn reduces overall economic activity. Unemployment rises and investment falls, which in turn leads to further reductions in aggregate demand. This cycle of continuing inflation is called a deflationary spiral.
Recall that in monetarist theory, Money Supply*Velocity of Money = Price Level*Output. According to monetarist economists, therefore, deflation is caused by a reduction in the money supply, a reduction in the velocity of money, or an increase in the number of transactions. However, any of these may occur separately without causing deflation as long as they are offset by another change - for example, the velocity of money could rise and the money supply could fall without causing a change in price levels.
The Great Depression
Most economists agree that the high levels of deflation during the 1930s made the Great Depression much more severe and long-lasting. It discouraged consumption, borrowing, and investment that would increase economic activity.