Many have heard of the economic term "inflation" and at least have a general understanding of its effect. The same cannot be said, however, for its opposite, "deflation."
In reality, the two are quite similar in both their concepts and how they are calculated. (This site’s Inflation Calculator shows both, depending on the years selected.) In fact, the easiest way to think of deflation is that it is happening when the inflation rate is below 0%, or negative.
Definition of Deflation
First, though, let’s give deflation an official definition. Deflation is a decrease in the average price of goods and services or an increase in the purchasing power of the standard unit of currency. Put more simply, deflation results in consumers able to buy more than they could before with the same amount of money.
Deflation is officially calculated in the United States by the United States Department of Labor, Bureau of Statistics (BLS). The bureau surveys prices for thousands of goods and services throughout the country and compares that data to previous samplings for its monthly Consumer Price Index, or CPI, report. If the CPI is lower than the previous period it is called deflation. For comparison, if the average is higher, it is called inflation. That is why we can also define deflation as a negative inflation rate.
View US inflation rates since 1914. There have been several years at deflationary levels.
Negative Consequences of Deflation
Cheaper prices may seem like good news for consumers. Most economists, however, would disagree. Prolonged periods of deflation can result in a recession and can devastate an economy.
If prices mark sustained deflationary levels that strike below the cost to produce goods and services, economic turmoil can ensue with production cuts, payroll reductions and lay-offs. When sellers receive less money for their products, they are forced to cut costs. This can take the form of buying fewer materials, cutting back on jobs or reducing payroll hours. Accordingly, those affected by these moves have less money to spend and make cost cuts of their own. Further, deflation can intensify debt by making it more expensive, cripple equity and widen home foreclosures.
Positive Example of Deflation
Deflation is not always a bad thing, however. For example, in the late 19th century there was a prolonged period of deflation in the United States brought about through advances in technology and manufacturing. Prices went down on most items but consumers still had money to spend.
Another related factor to consider is disinflation. On the surface, it may sound identical to deflation but it is another concept entirely. Disinflation is a slowing of inflation. For example, if inflation has been measured at a rate of over 2% but then drops to 1.7%, we are said to be in a period of disinflation since inflation is still occurring, but at a slower rate.
In order to control inflation, disinflation and deflation, the government looks to changes in fiscal and monetary policies. Fiscal policies are where the government changes taxes (revenue) and spending to affect the economy. Monetary policy is the control of the amount of money in circulation, typically through interest rate adjustments. Both policies are used to ensure a growing economy.