Definition of deflation
What is deflation?
Deflation is a measure of the general decline in the price of goods and services within a country or geographical area. Before you can talk about deflation, there needs to have been recorded declines in prices over a period of at least 3 consecutive quarters. If the decrease occurs over a shorter period, we talk about negative inflation (or of a negative inflation rate).
Consequences of deflation
Deflation increases the value of a currency. First of all, there is an increase in purchasing power for the holders of this currency (individuals, companies, etc.). This means that less money is spent on goods and services. If deflation is 2%, for example, this means that the price of an average basket of goods and services (defined by INSEE) decreased by 2%. Deflation (falling prices) can affect some goods and services more than others. At first glance, this seems positive. The problem is that deflation encourages households to postpone consumption and companies to postpone investment. Effectively, deflation increases the value of the currency within the country.
In the long term, deflation has very serious consequences. This decrease in consumption is harmful for companies. They reduce production levels and see their profits fall. This leads to lower wages and layoffs, which in turn leads to higher unemployment. All this fuels the decline in demand and causes more and more deflation.
Deflation is also detrimental to the country's imports. Imports have a higher cost because the currency loses value compared to other currencies.
It is an infernal spiral from which it is often very difficult to break out. The case of Japan, which has been in deflation for several decades, is a perfect example. That is why the central banks inject liquidity into the economy as soon as there is a risk of deflation.
The higher the deflation rate, the more disastrous the consequences for the economy. For countries with high levels of debt, the consequences are even more serious. This increases the debt burden.
Causes of deflation
Deflation is a phenomenon that can be due to a number of causes:
- Over-indebtedness: If economic agents have too much debt, repayment of their debts reduces their purchasing power. This therefore puts downward pressure on demand for goods and services in the long term. If demand becomes too low in relation to supply, prices fall. If demand falls too sharply, deflation can hit the country. This is the theory of debt-deflation expressed by the economist Fisher in the 1930s.
- Austerity policy: To combat excessive over-indebtedness, a country can use an austerity policy. This was the case in many countries after the subprime crisis in 2008. This policy consists of limiting credit, reducing public spending and raising taxes. All these elements contribute to lowering the money supply level and limiting demand for goods and services. This causes prices to fall, which can eventually lead to deflation.
- Hard currency policy: To increase the level of exports, a country may want to make its currency more attractive. The country's central bank then increases its interest rates and reduces the money supply so as to generate deflation.