Key Takeaways
- Deflation occurs when the value of the dollar increases, and the cost of goods and services drops.
- Deflation can cause an increase in unemployment figures and wage drops.
- People who are wealthy will suffer from greater losses during deflation. Their assets are more likely to decrease in value.
- The Federal Reserve tries to slow down deflation by increasing the money supply and encouraging spending.
Definition and Example of Deflation
Deflation is an increase in the real value of money as it relates to goods and services. You can purchase more in a negative inflation economy than you could in a positive inflation economy. Inflation and deflation are both measured using the Consumer Price Index (CPI), which measures the prices of a selection of goods and services that a typical consumer might purchase, spread over a set amount of time.
The rate of deflation can be calculated like this:
- Look at the price index of the current year (CPIc) and the price index of the previous year (CPIp). Subtract the current year (CPIc) from the previous year (CPIp).
- Divide the result by the CPI from the previous period.
- Multiply the result by 100 to get a percentage.
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The formula for the rate of deflation looks like this:
((CPIc – CPIp) / CPIc) * 100 = Deflation Rate
How Deflation Works
Deflation can be caused in a number of ways. It is often brought about by a fall in the total demand of goods and services, or an increase in supply.
Deflation can also be caused by a lack of money supply. Demand will go down if consumers reduce their spending, causing supply to go up and prices to go down. Investors see prices falling and begin to sell. Panic dreams. The market plummets.
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People often curb their spending even more when prices are falling, until prices bottom out. This pattern can compound the problem further.
There are several ways to counteract deflation and its effects, but not everyone agrees on the best methods. This is the topic of an ongoing debate in various economic camps. Many believe in flooding the economy with cash, which will in turn promote spending. By this logic, injecting more capital into an economy is the only way to reverse deflation for certain, because it attempts to change the only part of the equation that can be controlled: the money supply.
Alternative Methods
The Federal Reserve has introduced a method called quantitative easing. This approach attempts to increase inflation from the market end. The Fed starts by cutting the federal fund rate. This is the interest rate that banks charge each other for overnight loans. The Fed would then purchase a large number of long-term bonds, which will decrease the value of bonds and increase inflation.
Whether this unconventional tactic has the desired effect is still open to debate. The aim of policies such as these is to combat deflation by using the powers of the Fed to decrease the dollar’s value. The Fed can decrease the value of the dollar through an increase of the money supply or a decrease in the value of bonds.
How Deflation Affects the Market
People generally agree that deflation has a negative impact on stocks because lower prices over a long span of time tend to hurt bottom-line corporate net income. Deflation might encourage consumers to save money and reduce spending, adding to the problem. This practice also has a negative impact on top-line revenues. It erodes shareholder value.
Deflation is bad for stocks, but it can have a positive impact on some types of bonds. Government debt, such as that bought and sold in the form of US Treasury Bonds, is worth more because fixed payments take on greater value. That happens because interest rates tend to decrease during a deflationary period, which leads to increases in bond prices and profits for people who own bonds.
Deflation isn’t always a good thing for corporate bonds, however, especially those in companies that aren’t blue chip stocks. Deflation makes it tougher to make debt payments each year, because they become more costly.
Pros and Cons of Deflation
Pros Explained
- Lower prices: Consumers spend less money when deflation occurs, thus driving demand down. The drop in demand and the increase in supply lead to a decline in prices. Businesses have to lower prices in order to move their inventory.
- Cheaper to borrow money: The Federal Reserve will often lower interest rates as a way of combating deflation, trying to get people to spend more and invest less in fixed-income investments like bonds. The low interest rates also mean that people can borrow money much more cheaply. That is helpful for big-ticket purchases like cars, homes, or other items that may need to be purchased with loans.
- Shrinks wealth gap: The value of most assets falls during deflation. People with more wealth are more likely to hold assets other than cash, so they’ll suffer a greater loss compared to those with less wealth. People with lower income and mostly cash assets (rather than stocks or bonds) will benefit from the rising value of the dollar.
Cons Explained
- Lower wages for workers: Businesses also lose money as people hold on to their cash and begin to spend less. Drops in profit mean that they don’t have as much to pay employees, let alone offer raises.
- Higher unemployment: An increase in supply means that companies have to reduce their production of goods. Cutting down production means that less labor is needed. That can lead to layoffs. Factories or retail stores may permanently close in some cases. That not only hurts current workers, it also limits the pool of jobs open for people who are just starting to enter the workforce.