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Deflation is a decrease in the general price level of goods and services. It is the opposite of inflation, which occurs when the cost of goods and services is rising. Deflation can be caused by many different economic factors, including a decrease in the demand for products, an increase in the supply of products, excess production capacity, an increase in the demand for money, or a decrease in the supply of money or availability of credit.
Key Takeaways
- Deflation is a decrease in the general price level of goods and services; it is the opposite of inflation, which occurs when the cost of goods and services is rising.
- Deflation can be caused by many different economic factors, including a decrease in the demand for products, an increase in the supply of products, excess production capacity, an increase in the demand for money, or a decrease in the supply of money or availability of credit.
- The most dramatic deflationary period in U.S. history took place between 1930 and 1933, during the Great Depression.
- The most recent example of deflation occurred in the 21st century, between 2007 and 2008, during the period in U.S. history referred to by economists as the Great Recession.
Deflation can be a cause for concern among economists because a fall in the prices of goods and services can sometimes result in a fall in home prices, stock prices, and even people’s salaries.
There have been several deflationary periods in U.S. history, including between 1815 and 1860, and again between 1865 to 1900. One of the most dramatic deflationary period in U.S. history took place between 1930 and 1933, during the Great Depression. Deflation rarely occurred in the second half of the 20th century. In fact, the dramatic and consistent price increases from 1950 to 2000 has been unparalleled since the founding of the country.
The most recent example of deflation occurred in the 21st century, between 2008 and 2009, during the period in U.S. history referred to by economists as the Great Recession.
Deflation in the 19th Century
While the U.S. did not have a single national currency until after the Civil War, economists can still track consumer prices in terms of the exchange value of gold. During the War of 1812, a conflict fought between the United States and the United Kingdom from June 1812 to February 1815, prices rose and the U.S. government printed money and borrowed money heavily during this time. Buoyed by the rise of industrial mechanization after the war, the prices of goods dropped starting in 1815 and continued to drop until 1860. Even though prices were dropping, output grew consistently during this time and continued to grow at the same time that prices were dropping until approximately 1860, at the start of the Civil War.
During the period between 1873 and 1879, prices dropped by nearly 3% every year, yet real national product growth was around 7% during the same time period. However, despite this economic growth and the rise of real wages, historians have called this period “The Long Depression” because of the presence of deflation.
The Great Depression
In the 19th century, deflationary periods were the result of an increase in production, rather than a decrease in demand. During the Great Depression, deflation was the result of a collapsing financial sector and bank failures.
The deflation that took place at the outset of the Great Depression was the most dramatic that the U.S. has ever experienced. Prices dropped an average of nearly 7% every year between the years of 1930 and 1933. In addition to a drop in prices, there was also a dramatic drop in output during the Great Depression.
Deflation in the 21st Century
The most recent deflationary period in U.S. history was during the Great Recession, which officially lasted from December 2007 to June 2009. During this time period, there was a drop in commodity prices, particularly oil, and economists worried that deflation would lead to a prolonged recession, rising unemployment, and further strain on the U.S. economy.
In reality, the deflation that occurred was less severe than some economists predicted. While the exact reason for this is unclear, some economists have speculated that the unusually high cost of borrowing in late 2008 and 2009 put pressure on businesses and prevented them from cutting their prices.
Does Anyone Benefit from Deflation?
In the short run, consumers may benefit from deflation. As prices for goods and services fall, the buying power of the dollar rises. However, over the long run, a deflationary spiral can be harmful. When prices fall, profits can decrease for employers, resulting in layoffs and unemployment, for instance.
Who Is Hurt by Deflation?
Deflation can be particularly challenging for borrowers. Those who have previously taken out loans may be obligated to pay down debts in money that is now worth more than the amount originally borrowed.
How Do You Get Out of Deflation?
There are a number of policies that governments and central banks adopt when targeting deflation. Monetary tools include lowering bank reserve limits, which frees up liquidity to support bank lending, and lowering interest rate, which encourages more borrowing. Both these tools can help bolster new investments, spending, and consumption.
The Bottom Line
Deflation is a phenomenon in which general price level of goods and services decreases over time. It’s the oppositive of inflation, in which costs rise. There are many potential causes of deflation, including a decrease in demand for certain goods, increase in supply, decrease in availability of funds or credit, and more. There have been a few periods of deflation in U.S. history, most notably the Great Depression and the Great Recession.