Deflation refers to a decrease in the general price level of the economy. A fall in prices in particular markets, such as housing, share prices or the market for electronic goods or textiles is not the same as economy-wide deflation.

Most economists believe that disinflation or falling inflation is beneficial for the economy. A stable price level can lead to better decisions and a more efficient use of scarce resources. Lower inflation also helps to stabilize inflationary expectations. A decline in prices after an improvement in productivity is allows companies to cut costs and prices, thereby raising living standards.

The type of deflation that analysts fear is the kind that is broadly-based throughout the economy, long-lasting, and symptomatic of a weak economy stuck in recession. When prices are falling , consumers may decide to postpone purchases in the expectation of buying the item at a cheaper price later on. This causes a fall in demand and can create further price declines.

Deflation also causes real interest rates to rise, curbing demand. As well, falling asset prices (including housing and equities) reduce personal sector wealth and inflate the real value of debt, resulting in higher business failures and personal bankruptcies. It is clear therefore that deflation in the economy brings risks as well as opportunities. This is something that a government and the monetary authorities (i.e. the Central Bank) might be concerned to avoid.

DEFLATION AND ECONOMIC POLICY

Deflation can normally be controlled by an expansionary monetary policy with the Central Bank or the Government allowing the money supply to expand. This causes interest rates to fall and stimulates consumer spending and investment demand. Occasionally though, when prices are falling, lenders may call in loans or refuse to lend out to potential borrowers. This is known as a credit crunch.

Cutting interest rates may not be sufficient during a credit crunch. In this case, expansionary fiscal policy (lower direct and indirect taxes and higher government spending) is often prescribed to cure deflation. One reason deflation is difficult to cure is that nominal interest rates cannot fall below zero, while prices of goods and services can fall for a long time. In this event, monetary policy is unable to prevent higher real interest rates and the economy spirals downwards towards a slump caused by falling prices, contracting output, falling investment, plant closures and increasing levels of job losses in those industries affected.