Why Deflation Can Be a Bad Thing

At first sight deflation would appear to be a good thing for most of us. After all, the general idea is that prices go down and everything costs less. Why wouldn´t that be a good thing for most people?

To understand the effects of deflation and why it is a bad thing we need to first of all consider what it actually is.

What Is Deflation?

Deflation, in an economic sense, happens when the inflation rate falls below zero and the price of goods and service start to fall. Basically, it is the opposite of inflation in that you can buy more stuff with the same amount of amount than you could have done a week or a month before. Your money is worth more with every passing day in a deflationary situation. This sounds good if you want to buy some more pizza, or a new house or a new car. In fact, anything you want to buy is going to look like a bit of a bargain at first. However, one of the symptoms of deflation is a scarcity of cold, hard cash, while it has some very nasty effects that might not seem obvious at first.

Why It Is Bad

While the prices of goods and services will start to fall, it isn´t all good news for us. For example, if you have a loan then one of the effects of deflation can be that it costs you more of your spending power to pay it back. For example, if the rate of deflation is 5% annually then it will cost you 5% more of your spending power every year to pay it back. This means that any money you borrowed before the deflation kicked in is going to cost you a good deal more to pay back than you had expected it do, even if the interest rate and repayment amounts don´t change. There is also the theory that a lot of people will hold off on buying things because they expect prices to carry on falling. Why buy something for $100 when it will probably cost you $90 before too long? This leads to lower consumer demand and means that the prices keep on falling over time. You know that your savings will be worth more tomorrow than they are worth today, so why spend them?

Lower Wages and Demand

Another of the effect of deflation that no one wants to see has the technical name of deflationary spiral. What this means is that as prices fall so does the demand for services and, in turn, wages. Of course, this carries on spiraling, as wages gets lower so demand drops more and prices fall even further, leading to lower wages, reduced demand and so on. Some economists aren´t convinced that the deflationary spiral can really exist, while others cite the Great Depression as a prime example of it in action. Regardless of the technicalities of it all, if deflation happens then you can probably expect to earn less money sooner or later. If you own your own business then you can also expect to see less demand for your products or services.

Do you think that deflation would have any upsides for you?

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