What is... | September 3, 2013

What is deflation?

The prices of goods and services persistently falling might sound appealing as it suggests money will go further for longer. But a general fall in prices – known as deflation – actually tends to be a bad sign for an economy.

Prices are driven by a range of factors, including supply and demand, willingness or ability to pay, exchange rates and more. If there is deflation, the prevailing view is that an economy is out of balance and it causes problems, with debt tending to be more difficult to pay off.

Targeting a gentle rise
In fact, avoiding deflation is so important that a major responsibility of many central banks is to try and balance the economy to get price stability.
In the United Kingdom, for example, the Bank of England’s Monetary Policy Committee must write a letter of explanation to the Government’s Chancellor of the Exchequer if inflation (as measured by the consumer price index, or CPI) is more than one percentage point above or below the two per cent target.
An example of one of these letters, from February 2012, is here.
Other central banks have similar targets.
As ING Group chief economist Mark Cliffe writes in his What is … inflation article, inflation does not mean that all prices are rising – or that they are rising at the same rate. But it means that the average in an agreed, weighted basket is going up.
Deflation happens when the rate of inflation falls below zero – not when the rate of inflation is slowing (which is known as disinflation).

What if… deflation happens?
If prices persistently fall, savers might feel a benefit in the short-term, as their purchasing power will rise.
But prices are usually falling because of wider problems in the economy, often associated with slow economic growth (or GDP). This also can affect employment rates, interest rates and other important parts of life.
In the past, periods of deflation have often gone hand-in-hand with economic recessions or depressions.

Japan’s deflation challenge
Japan has struggled with deflation for decades but the Prime Minister re-elected late in 2012, Shinzo Abe laid out radical plans to address this and other problems in the economy.
In the April 2013 economic update video for eZonomics, ING head of macroeconomics Maarten Leen explains how the Bank of Japan doubled its inflation target to two per cent and announced large scale quantitative easing (QE) that is set to double the country’s money supply.
One of Japan’s major challenges is its rapidly aging population, and in June 2013 academics were still undecided if the measures went far enough to solve Japan’s deflation problem.


eZonomics team
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