In contrast to inflation, deflation is an economic phenomenon characterised by a generalised and sustained fall in the prices of goods and services. While this may initially seem like good news for consumers because it increases their purchasing power, it can negatively affect the economy.

Inflation is an economic concept linked to the evolution of the Consumer Price Index (CPI) that almost everyone is familiar with, but what do we know about deflation? Contrary to inflation, deflation or negative inflation is a generalised and sustained decline – for at least two semesters – in the prices of goods and services.

Deflation is often associated with economic crises and recessions. It occurs when the supply of goods and services in an economy exceeds demand, forcing companies to cut prices to sell production and avoid accumulating large amounts of stocks.

In principle, lower prices may seem to be a good thing, since it will lead to a price adjustment that favours consumers. In other words, if wages are maintained, people’s purchasing power increases. But it can also generate a vicious circle of falling prices, leading to a reduction in spending and causing consumption and investment to stagnate, resulting in lower economic growth and higher unemployment.

Negative effects of deflation on the economy

Deflation can discourage consumption: if we believe that the price of a product will continue to fall, we will postpone our purchasing decision in the expectation of a better price. Therefore, if this sentiment is maintained over time and all consumers postpone their purchasing decisions, businesses will be forced to continue lowering the prices of their products due to the lack of sales. This effect is known as a deflationary spiral.

This will lead to lower profits for businesses, which will have to cut costs, so they will tend to also cut wages or lay off workers, causing unemployment to rise. Thus, deflation can create or worsen a recession, triggering long-lasting economic crises.

On the other hand, asset prices, such as stocks and real estate, may also fall during periods of deflation, negatively affecting the net worth of individuals and firms. This effect can make it more difficult to service debts by increasing the real burden of debt, which could lead to households and firms being unable to meet their obligations.

That is why central banks aim for price stability in their monetary policy and control of the money supply, aiming for inflation of around 2%. These measures are implemented to mitigate the possibility of deflation and thus avoid having to inject money into the economy to increase the money supply, reducing the value of money to raise prices.

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