Deflationary spiral

In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below 0% (a negative inflation rate). Inflation reduces the real value of money over time; conversely, deflation increases the real value of money – the currency of a national or regional economy. This allows one to buy more goods and services than before with the same amount of money.

Economists generally believe that deflation is a problem in a modern economy because it may increase the real value of debt, especially if the deflation was unexpected. Deflation may also aggravate recessions and lead to a deflationary spiral.

Deflation is distinct from disinflation, a slow-down in the inflation rate, i.e. when inflation declines to a lower rate but is still positive.

In the IS–LM model (investment and saving equilibrium – liquidity preference and money supply equilibrium model), deflation is caused by a shift in the supply and demand curve for goods and services. This in turn can be caused by an increase in supply, a fall in demand, or both.

When prices are falling, consumers have an incentive to delay purchases and consumption until prices fall further, which in turn reduces overall economic activity. When purchases are delayed, productive capacity is idled and investment falls, leading to further reductions in aggregate demand. This is the deflationary spiral. An answer to falling aggregate demand is economic stimulus to increase demand, either from the central bank, by expanding the money supply, or by the fiscal authority, by increasing public spending or decreasing or deferring taxes (see fiscal multiplier).

Deflation is also related to risk aversion. Where the risk-adjusted return on assets drops to near zero (or even negative), investors and buyers will hoard currency rather than invest it, even in the most solid of securities. This can produce a liquidity trap or it may lead to shortages that entice investments yielding more jobs and commodity production. A central bank cannot, normally, charge negative interest for money, and even charging zero interest often produces less stimulative effect than slightly higher rates of interest. In a closed economy, this is because charging zero interest also means having zero return on government securities, or even negative return on short maturities. In an open economy it creates a carry trade, and devalues the currency. A devalued currency produces higher prices for imports without necessarily stimulating exports to a like degree.

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