Deflation means that the general price level in a country decreases. The amount of money itself decreases, which results in the actual value of the money increasing.
So, what is deflation?
Deflation means that the general price level in a country decreases, in other words that prices have fallen over a longer period. Deflation is the opposite of inflation (which means an increase in the general price level).
When consumption declines, it leads to reduced production and growth, which in turn leads to deflation. Deflation means that the money supply decreases and that the money value increases, ie that every dollar becomes more valuable.
Deflation is detrimental to the economy
Deflation is considered something very bad and harmful for an economy, partly because it can lead to reduced consumption, which in turn can lead to high unemployment in the country.
There is a consensus that deflation caused by a reduction in the amount of money is harmful and problematic, but some believe that if it instead arises from a large increase in the supply of goods and services, it is something positive.
How does deflation occur?
Deflation is caused by a shift in supply and demand for goods / services and money – or specifically by a decrease in the supply of money (money supply) and an increase in the supply of goods / services.
When deflation occurs in an economy, it means in many cases that a recession is near or on the way.
When the money supply decreases, it leads to increased caution and saving among consumers and other players because they are worried about the country’s economy.
This means that consumption is reduced and that there is an oversupply in the market. And that ultimately leads to deflation.
Historically, deflation has often been linked to an increase in the supply of goods / services (thanks to increased productivity) without an increase in the money supply, or to a decrease in the demand for goods / services combined with a decrease in the money supply.
How can deflation be counteracted?
Deflation can be counteracted by the central bank increasing the money supply, such as by buying newly issued government bonds with newly created money, with which the government can stimulate the economy.
Another common method is to lower the interest rate level.
This provides an economy for borrowers, which should mean that more people choose to borrow, and it is likely that consumption and the economy will start up again thanks to increased demand.
What are the consequences?
The consequences of deflation are lower growth and that the country’s GDP is growing more slowly than it has done before.
This in turn leads to many companies getting a worse result as consumers’ purchasing power decreases and the ordinary employees may receive a relatively lower payment.
If there is strong deflation, companies may be forced to lay off staff as demand has decreased. Deflation can thus go hand in hand with unemployment and reduced wages.
Real debt increases when there is deflation in an economy. Households and companies thus have an increased debt burden, especially if compared with inflation of 2 percent (which is a common inflation target).
Deflation thus disadvantages those who have borrowed money, while it benefits those who have saved money – and in inflation it is the opposite.
Deflation usually occurs during recessions, or close to the end, and when the recession worsens, deflation also tends to do so.
Companies are desperately trying to get people to buy their goods or services by lowering prices, which can make the situation worse.
What is a deflationary spiral?
A deflationary spiral is a situation where price declines lead to lower consumption (demand), which leads to lower production, and this leads to lower wages and possibly people losing their jobs, which in turn leads to further price reductions.
The problem simply exacerbates its own cause.
This risks severely damaging the economy and having major negative consequences for both individuals and companies.
As consumers have less money to shop for (due to lower wages) and are inclined to lower prices, many are waiting to consume – which, as I said, makes the problem even worse.
A deflationary spiral thus leads to a sharp decline in activity throughout the economy, and such a situation can be difficult to stop.
Deflation means reduced consumption
As I have mentioned, when prices have fallen for a long time, deflation occurs in a country. The reason is that the amount of credit and money has decreased.
When this happens, the usual reaction is that people stop consuming. This in turn leads to the factories stopping producing goods at the same rate as before and growth slowing down.
When this happens, the country has ended up in deflation. Deflation is the opposite of inflation. Inflation means that the general price level increases, which in turn leads to a decrease in the actual value of money.
In other words; you can buy fewer items for the same amount as before.
The problem with deflation is that growth in society is declining, as production itself is declining. This also means that gross domestic product (GDP) will increase more slowly than before.
Consequences of this include that companies generate poorer results because their customers no longer shop as much.
In the worst case, deflation leads to staff having to be laid off. As an entrepreneur, it is important to always have the right insurance that can protect the business in the event of deflation.
What is GDP?
GDP stands for gross domestic product and is the value of all production that has taken place in a country for one year. GDP is therefore often used as a measure of a country’s economic health.
When calculating GDP, you can see, for example, that Sweden’s GDP has increased from one year to another. But here it is important to also include the deflation percentage in the calculation.
If there is deflation in a country, the value of money decreases and GDP may not be as high as one might first think.
How is deflation calculated?
Deflation is calculated using the CPI, consumer price index. It is an index that measures the average price level of consumer goods.
Deflation is calculated according to the following formula:
To calculate deflation (or inflation), the consumer price index (CPI) is used.
This is what the formula looks like: CPI 2021 – CPI 2020 / CPI 2020 x 100
What distinguishes today’s deflation from the 1920s?
Recently, prices have fallen, but not very much. In addition, the economy is not in a serious crisis, even though we are still living in the aftermath of the financial crisis of 2008.
In the 1920s, the fall in prices was all the more dramatic. Prices fell by 35 percent and wages by the same amount. A quarter of industrial production disappeared.
Exports and investments were halved. Unemployment dropped from 5 to 25 percent. Today it is at a stable level.