What Is Deflation?

The definition of deflation is when asset and consumer prices continue to fall. This may seem like a great thing to consumers, except that the cause for deflation is a long-term drop in demand. Unfortunately, a drop in demand means that a recession is already underway, with job losses, declining wages, and an ongoing decline in the value of your home and your stock portfolio. Deflation is a result of businesses dropping prices in a desperate attempt to get people to buy their products.

Officially,deflation is measured by a decrease in the Consumer Price Index. However, the CPI does not measure stock prices, which retirees use to fund purchases, and businesses use to fund growth. It also does not measure housing prices, instead using rental equivalent. This often lags home price declines, and underestimates deflation in the CPI.

To combat deflation, the RBI executes an expansionary monetary policy. It reduces interest rates, and increases the money supply in an attempt to jump-start economic growth. In addition, the government can offset deflation with expansionary fiscal policy. It can put more money into circulation by lowering taxes, increasing government spending, and incurring a temporary deficit to do so. Of course, if the deficit is already at record levels, that tool may no longer be available.

Like inflation, deflation is very difficult to combat once it is entrenched. As businesses and people feel less wealthy, they spend less, reducing demand further. Prices drop in response, giving businesses less profit.