WHAT IS DEFLATION..?

In common usage deflation is generally considered to be "falling prices". But there is much more to it than that. Often people confuse deflation with disinflation or with Depression (as in "the Great Depression"). These three terms are related but not synonymous.

DEFINITION OF DEFLATION

“A decline in general price levels, often caused by a reduction in the supply of money or credit. Deflation can also be brought about by direct contractions in spending, either in the form of a reduction in government spending, personal spending or investment spending. Deflation has often had the side effect of increasing unemployment in an economy. Deflation is the opposite of inflation”

INFLATION & DEFLATION

LET’S ASSUME :-

• If the quantity of money increases to $20 (without increasing the quantity of goods) the price of the goods will increase to $2.00 - that is “ INFLATION”

• If, however, the quantity of money decreases to $5.00 the price will fall to 50¢ “DEFLATION”.

• For more understanding of both Inflation and Deflation we need to understand Supply and Demand. Just like every other commodity there is a supply of and a demand for "Money

DEMAND

If everyone on our island already has one of the items available and no one

needs any more, naturally the price will also fall, as sellers try to find someone to take

them off their hands.

IN SUPPLY

So far we have dealt with the supply of money, the supply of goods and the

demand for goods, but what about the demand for money?

DEMAND FOR MONEY

Is it possible that the demand for money could increase or decrease? Generally,

the demand for money is measured by how much people are willing to pay to borrow

it (i.e. interest rates). If inflation is high, interest rates will have to be higher to

compensate for the loss of purchasing power. But also if the demand for money rises

banks can charge more to loan it. Conversely, if the demand for money falls interest

rates will also fall.

WHAT CAUSES DEFLATION

This form of deflation is the good type. Everyone assumes that deflation is bad because the last major deflation that we had was during the "Great Depression" so deflation and Depression are synonymous in many peoples minds. In actuality if prices go down because the goods can be manufactured more cheaply this ends up increasing everyone's wealth.

There are four causes for Deflation:-

• Decreasing Money Supply

• Increasing Supply of Goods

• Decreasing Demand for Goods

• Increasing Demand for Money

IS DEFLATION GOOD OR BAD?

• Deflation itself is neither good nor bad. It depends on the cause of the deflation whether people will suffer or rejoice. If the cause is increasing supply of goods that would be good.

• If deflation is caused by a decreasing supply of money as in the great depression, that would be bad. The stock market crash sucked all the liquidity out of the market place, the economy contracted, people lost their jobs and then banks stopped loaning money because people were defaulting. The problem compounded as more people lost their jobs and money supply fell further causing more people to lose their jobs, etc.