Hey there! So, if you watched my video about inflation, you will say that inflation is bad because it makes everything expensive. Prices rise, the value of money drops, and if inflation is too high, everything is in chaos.
So, you might be wondering, if high inflation means prices will go up, then logically, wouldn't minus inflation make prices go down? So, minus inflation sounds like a great thing! Why don’t all countries do that?
Well, that condition is called deflation. And even though deflation does make everything cheaper, it’s not necessarily better than inflation. Why?
Well, in this video, we will talk about what deflation is, how it works, and why it can be just as bad, or even worse, than inflation. Section 1. What is deflation?
Deflation is when prices go down and money’s value goes up. Simply put, deflation is just the opposite of inflation. Something that you need to know is, that deflation is different from disinflation.
Disinflation means inflation is going down. For example, if inflation was 2% then went down to 1%, it means the economy still has inflation, but it’s less. While deflation means minus inflation, for example, -1% inflation is 1% deflation and so on.
So, if inflation makes prices more expensive, then deflation makes prices cheaper. Not only that, while inflation makes the value of money go down, deflation makes the value of money go up. For example, if $3 used to buy you just one burger, after deflation, that same $3 can buy you the same burger and a drink.
This means the price of the burger went down and your money’s value went up. With the same amount of money, you can now buy not only a burger but also a drink. Your money just became more powerful and valuable!
Sounds amazing, right? Well, it’s not that simple. To understand why, we need to know what causes deflation and its impacts.
Section 2. Why does deflation happen? As deflation is just the opposite of inflation, so the causes of deflation are mostly also just the opposite of the causes of inflation.
Deflation can happen for different reasons, but we’ll talk about the most common ones. The first cause is a decrease in money supply. You probably know that if there’s too much money in the economy, it leads to inflation, making prices go up.
So, what happens if there’s too little money? Of course, it causes the opposite: deflation. But, how does money supply decrease?
This usually happens after a major crisis. For example, during the 2008 financial crisis, many people who had loans from banks went bankrupt and couldn’t repay their debts. To protect themselves, banks stopped lending money.
As people couldn’t borrow money, they had less money. When people had less money, they naturally reduced their spending, which led them to buy fewer goods and services. This decrease in spending causes a drop in demand, which we’ll discuss in the next point.
The second cause is decrease in demand. Imagine that you’re a baker who has a bakery that sells bread. A loaf of bread costs $5.
Now, let’s say every day you can sell about 10 loaves of bread to your customers. Well, that’s great! As mentioned earlier, the decrease in the money supply means most people have less money.
When people have less money, they will lower their spending and save their money. So, the impact is now you can only sell 5 loaves of bread per day instead of 10. You notice that demand continues to fall, and you fear your bread won't sell, causing it to go stale.
Not only you, but all businesses are worried about unsold products piling up. So, all businesses, including yours, will naturally lower their prices to attract buyers. As people cannot afford to buy anything, businesses are forced to lower prices to attract buyers, leading to massive price decreases.
That’s deflation. The third cause is increasing in supply. Continuing from the previous example, because demand has dropped and bakeries decreased their production, there’s less competition among bakeries to buy wheat.
For suppliers, like wheat farmers, this leads to an oversupply problem. If there are normally 6 bakeries, each buying 2 bags of wheat (a total of 12 bags), and the wheat farmers produce 12 bags, then there’s no problem. But, as deflation hits, let’s say 2 bakeries cannot survive and go out of business, leaving only 4 bakeries left.
As the demand keeps falling, these 4 bakeries reduce their orders from 2 bags to perhaps 1 bag, so the total demand is now 4 bags of wheat. While the wheat farmers still produce 12 bags of wheat. This means there’s 8 bags of unsold wheat.
To avoid letting their wheat go to waste, farmers lower their prices further and decrease their production to match demand. With cheaper wheat, it costs you less to bake bread. However, since demand remains low, you have to continue lowering prices to attract buyers, meaning the bakery does not generate more profit.
So, in this scenario, the wheat price falls, the bread price drops, and all the prices are falling. At the same time, production is also decreasing. So, the economy just keeps shrinking and that causes recession.
So, those are some common reasons why deflation can happen. Of course, there are many other factors that can cause deflation, but for this video, I will keep it simple. Now, let’s move on to the next section!
Section 3. Is deflation bad? In my previous inflation video, I explained that low inflation is actually good for the economy.
Similarly, low deflation can also be good for the economy, as it helps lower prices and makes things more affordable. However, just as too much inflation is bad for the economy, too much deflation can be even worse than inflation! The Great Depression of the 1930s in the U.
S. , which is regarded as one of the worst financial crises in history, was caused by massive deflation. Wait, how can falling prices and the rising value of money cause a crisis?
Let’s break it down with an example: Imagine you work at a shoe factory. Before deflation, your factory was producing and selling shoes at $60 a pair. The factory makes 1,000 pairs of shoes every day, and everything is going smoothly.
But then, deflation hits, and prices for everything start to fall. The factory notices a drop in shoe demand as well. Before, they could sell all 1,000 pairs of shoes, but now, they’re only selling about 800 pairs a day.
The factory owner, seeing the falling demand, decides to cut prices to attract more customers. So, the price of shoes drops from $60 to $55. But people aren’t rushing to buy.
They think, “Why buy now? The price will probably fall even more. I’ll just wait until they’re cheaper.
” Also, during deflation, the media will report that the economy is struggling, which leads people to save their money out of fear. So, the factory lowers the price again, to $50. Sales increase slightly but still not enough.
They keep cutting the price to $45, $40, and even lower, but customers still hold off. Now, you might say, "This isn’t a problem since the materials for the shoes, like rubber, are also seeing a drop in demand and price. " And you’re right!
The rubber company that supplies your factory faces less demand, and its rubber stock is piling up. So, the rubber company cuts its prices to attract shoe companies to buy. With this, your shoe factory can keep producing shoes at a lower cost and still sell them at a lower price, helping to maintain some profit.
But remember, the rubber company cannot lower the price of rubber forever! There’s a limit because the rubber company still needs money to extract the rubber from trees and pay the workers. Eventually, when the rubber company reaches the lowest price they can sell at, and no one wants to buy your factory’s shoes, your factory can no longer lower its prices.
The factory still has to pay workers’ wages, production costs, electricity, and other expenses. So, the factory is forced to lay off workers, forgo profits, and cut production from 1,000 pairs of shoes per day to 700 or fewer. At this point, your country enters a recession.
A recession occurs when businesses cut production, causing the economy and GDP to shrink for over six months. So, in this situation, let’s say you’re lucky not to be laid off, but your boss cuts your wages to keep the factory in business. However, if deflation gets really bad and turns into spiral deflation, the situation worsens.
Spiral deflation occurs when businesses continue to collapse, resulting in widespread job losses and even less money circulating in the economy. The rubber company that supplies your shoe factory goes bankrupt too. Now, your factory is trying to survive by laying off workers, cutting wages, and reducing production to 500, 300, or even just 100 pairs of shoes per day.
But eventually, the factory gives up and goes bankrupt. Now, you’ve lost your job and income. You try to find another job, but all businesses are collapsing, laying off workers, and there are simply no vacancies.
So, you’re left in a situation where everything is cheap, but nobody has money to buy anything. This is the danger of deflation. It can cause a cycle where lower prices lead to lower wages, fewer jobs, and lower demand, which will cause recession.
And if it continues to even lower prices, and the economy spirals downward into depression. Depression is when the recession got so bad and that’s why too much deflation is actually a nightmare. Since you don’t want too much deflation, so how can it be controlled?
Well, that’s what we’ll talk about in the next section! Section 4. How to control deflation?
Since too much and too long deflation is not good for the economy, so how to control deflation? Well, in the previous inflation video we’ve talked about how the central bank and the government control high inflation and low inflation. So, the central bank and the government will use similar methods to control deflation as they do to control low inflation.
As deflation means too little money in the economy, so the central bank will use the monetary policy while the government will use the fiscal policy to inject more money into the economy and combat deflation. The central bank can control deflation using something called monetary policy. Monetary policy is just a fancy term for the decisions they make to adjust interest rates and manage the money supply.
So, here is some of their policies. The first one is lowering interest rates. The central bank will lower the interest rates to make borrowing money cheaper, encouraging people to take out loans.
With more money available, people spend more, helping the economy recover and ending deflation. The second one is increasing the money supply. The central bank can increase the money supply through expansionary open market operation.
The central bank will buy treasuries like government bonds from commercial banks at higher prices to inject money into the economy. With more money from the central bank, these banks can lend more to people. As all banks have more money to lend, they are also competing to lower their interest rates to lure people.
People will borrow more money meaning people will have more money and people will spend more. The demand is increasing, and business back to operation, and deflation can end. The third one is quantitative easing.
Sometimes, lowering interest rates and open market operation are not enough to cure deflation, so the central bank will use quantitative easing. Quantitative easing is when the central bank decides to print new money, then buy lots of government bonds and corporate bonds to inject money into the economy. This will encourage the government and corporations to spend more money, increasing inflation.
As you know deflation is the opposite of inflation, so during deflation, the central bank will purposely make inflation to beat deflation. While the central bank handles monetary policy, the government uses fiscal policy to control deflation. Fiscal policy is also just a fancy term of decisions taken by the government like adjusting taxes and spending.
So, here is some of their policies. The first one is lowering taxes. Well, when deflation happens, it means money is too little in the economy.
So, the government must increase the money supply by letting people to keep more money. So, the government will reduce taxes so you can keep more money and can spend and buy more things. Which will cause inflation and escape the deflation.
Although the government rarely lowers taxes, but at least, this is the theory. The second way is by increasing government spending. For example, if the government wants to build a bridge, they will buy materials like cement, bricks, and more.
They will also hire engineers, workers, and other specialists to construct the bridge. Just imagine, by building one bridge, how many people are getting paid? And as you know, there’re tons of government’s projects across the country and involving thousands of construction stores, thousands of engineers, and hundreds of thousands of workers across the country.
The projects are also worth millions to even billions of dollars. So, if the government increases its spending, it will increase the money supply in the economy, causing inflation and reducing deflation. As I mentioned earlier, we discussed these methods in more detail in the inflation video, so if you’re interested, you can watch the video.
Link in description. Section 5. How to protect yourself from deflation?
Since too much deflation can cause massive unemployment and crises, you might wonder how to protect yourself during deflation? Well, these are some strategies that you can use: First, reduce your debt. During deflation, the value of money increases, which is great if you have cash.
However, if you have loans or are in debt, deflation can be a nightmare. As the value of money rises, the real value of your debt also increases. This means you will owe more in real value, making repayment harder, especially when interest is added.
Second, invest in high-quality bonds. Bonds, such as government bonds or highly rated corporate bonds, are considered low-risk investments. During deflation, many investors sell riskier assets like stocks and focus on bonds, seeing them as a safer option.
Even though the returns may be low, the fixed income and lower risk make them an attractive choice during economic crises such as deflation. Third, maintain a cash reserve. Since deflation increases the value of money, having cash on hand is the best choice.
Stocks often perform poorly during deflation. However, if you want to invest in stocks, focus on companies with high cash reserves and little or no debt. These companies are better positioned to survive during deflation.
In conclusion, deflation is when prices go down and money’s value goes up, which is just the opposite of inflation. While small, short-term deflation can bring benefits, like lower prices for goods and services that allow consumers to buy more with their money. However, if deflation lasts long term, it can create a cycle of reduced spending and investment, leading to lower demand, wage cuts, job losses, increased debt burdens, and eventually a recession or even depression.
That’s why most countries aim for about 2 to 3% inflation per year to avoid too high inflation that is bad and too low inflation or even deflation that is also bad. Although deflation is rare compared to inflation, understanding both inflation and deflation helps us understand the economic landscape better and make informed financial decisions. If you want me to make other videos explaining these topics, please like and subscribe.
Thanks for watching.
