Deflation: Meaning, objective, cause - Glossary - BUX

What does deflation mean?

Deflation is an economic situation in which the average price level of products and services falls structurally. It is not just one month or one product, but a broad and persistent pattern. Deflation means that your money is worth relatively more because products become cheaper. As a consumer, this can feel like a gain for your purchasing power, as you can buy more products for the same amount. However, beneath the surface, deflation can lead to a negative spiral in the economy.

Not a BUX investor yet? Create your account

Where does the term deflation come from?

The word deflation comes from the idea of ‘deflating’. While inflation is derived from the Latin inflare (to blow up), deflation stands for the opposite: the price level deflates.

What is the purpose of deflation?

Deflation usually has no purpose, as it typically indicates economic contraction. Central banks, such as the European Central Bank, actually strive for a slight inflation of around two per cent per year.

Because of this, they generally try to prevent deflation so that consumers and companies spend and invest money with confidence. The actual goal is therefore usually price stability, not a continuous decline. Extreme rises and falls in prices can have an impact on economic growth.

How do you measure deflation?

The consumer price index (CPI) is the benchmark that statisticians use to measure deflation. The central bureau of statistics in each country tracks how much your average basket of groceries costs. When that CPI falls structurally over a longer period, it is referred to as deflation.

What is the cause of deflation?

There are various causes of deflation, such as lower demand, oversupply, less money in circulation, and technological developments.

1. Less demand in the economy When consumers spend less, the demand for products falls. Producers then lower their prices to still make sales. If this happens broadly, deflation occurs. This happens, for example, because consumers are uncertain about their job or income and wait longer to buy products.

2. Oversupply of products If companies produce more than consumers want to buy, they must compete on price. Lower prices can then lead to a general decline.

3. Shrinking money supply The amount of money in circulation also plays a role. When banks become stricter with credit or the money supply shrinks, it can cause deflationary pressure. Central banks can sometimes find it harder to provide extra stimulus when interest rates are already very low.

4. Development and progress Sometimes prices fall simply because it becomes cheaper to make products. Developments such as technological progress, more efficient production, or cheaper raw materials can lead to lower prices.

What are the advantages of deflation?

Deflation also has positive sides, which are mainly in the consumer’s favour. Namely:

• Your purchasing power can increase; your money is worth more.
• Lower prices make products more accessible.
• Savings retain relatively more value than during high inflation.

If deflation is caused by technological progress, it can even indicate more efficient production and growth. But here lies the nuance: the benefits depend heavily on the cause. Deflation due to innovation feels different than deflation due to economic contraction.

What are the disadvantages of deflation? The downward spiral

Deflation also has a downside: it can lead to a deflationary spiral. This is how it works:

• Prices begin to fall: In an already weak economy, prices start to fall broadly. Shops lower prices to attract customers.
• Expectations change: Consumers and companies expect further price drops. Why buy that car now if it will be cheaper next month? Spending is postponed.
• Companies feel the pain: Turnover and margins fall. Companies react by cutting costs. This includes fewer staff, lower wages, and fewer investments.
• Unemployment rises: More people lose their jobs or see their income fall. Total demand in the economy collapses even further.
• Credit dries up: Banks become more cautious. Lending becomes more difficult, even for companies that want to invest. Prices fall further.
• More pressure on debts: If debts remain nominally the same, there is more pressure to pay them off, such as a loan or mortgage.

It is a negative spiral that reinforces itself and is difficult to break.

Does deflation occur often in the Netherlands?

Prolonged deflation occurs relatively rarely in the Netherlands. Yet there have been periods when prices fell temporarily, for example due to energy prices or a sharp drop in consumption. A recent example of a deflationary month in the Netherlands was in 2023. In October of that year, inflation was -0.4 per cent as a result of falling energy prices, according to the CBS.

Deflation versus inflation

Inflation and deflation are opposites. With inflation, your pounds become worth less because prices rise. With deflation, your pounds actually become worth more because prices fall. Central banks seek a middle ground: not too much, not too little. In the table below, you will find the main differences at a glance.

Which is worse, inflation or deflation?

Whether inflation or deflation is worse depends on the situation. High inflation can make savings worth less and cause uncertainty. Prolonged deflation can be damaging to economic growth. Because consumers postpone spending and companies invest less, the economy can stall. Most economists find stability more important than extremes. Moderate inflation is often seen as healthier than persistent deflation.

How can governments and central banks combat deflation for economic growth?

Governments and central banks have several tools to combat deflation. They can do this by:

• Lowering interest rates to make borrowing more attractive.
• Buying government bonds to increase the money supply.
• Stimulating the financial system.
• Reducing taxes.
• Increasing government spending.

Not a BUX investor yet?
Create your account in a few minutes and start building your wealth.

Investing involves risks. You can lose your investment.

All views, opinions, and analyses in this article should not be read as personal investment advice and individual investors should make their own decisions or seek independent advice. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication.