Deflation is the general decline in prices for goods and services occurring when the inflation rate falls below 0%.
Deflation can occur naturally when the money supply(a tool of monetary policy) of an economy is fixed. In times of deflation, the purchasing power of a currency and wages are higher than they otherwise would have been.
Deflation causes the cost of nominal goods, services and labour to be lower if money supply remains the same.
What causes deflation?✔
Deflation is primarily caused by two things. A fall in demand for goods and an increase in economic productivity.
What causes a fall in demand?✔
A fall in demand can be caused by reduction in government spending(hence money supply), an increase in interests rates which make it more expensive to borrow money for shopping, stock market failure which causes consumers to fear for the worse, spend less and save more.
What causes Economic productivity?✔
Economic productivity could be due to an advancement in technology. This means we are more efficient at producing goods or services, which brings the cost of production lower and these costs are then passed on to consumers in the form of lower prices.
For context, in 1980 the cost of one gigabyte of data was $437,500 and in 2010 it fell all the way to 3 cents. This advancement increased the savings passed on to consumers and spawned further productivity.
The Economic viewpoint on deflation is also changing, due to the great USA depression which deflation (caused by monetary policy) played a big part in, economists viewed deflation as the big bad monster but recent research has shown that most economic depressions occur without deflations and that most countries who suffered a deflation were still operating in optimal economic conditions.
Most central Banks are still obsessed with preventing deflation and aim for a 2% inflation rate as the optimal position.
Why is deflation bad?✔
Deflation is often viewed as the first step to a recession and it encourages people to defer spending as they continually expect prices to fall further. This then puts pressure on manufacturers to continually lower prices to meet consumer expectations.