What is Deflation? - Definition, Causes & Effects

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  • 0:01 What is Deflation?
  • 0:25 Causes of Deflation
  • 1:48 Effects of Deflation
  • 3:13 Lesson Summary
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Lesson Transcript
Instructor: Shawn Grimsley

Shawn has a masters of public administration, JD, and a BA in political science.

You may not realize it, but prices sometimes go down, and that's not always a good thing. In this lesson, you'll learn what deflation is, its causes, and its effects. A short quiz follows the lesson.

What is Deflation?

Deflation occurs when the general prices of goods and services of an economy falls for a significant period of time. In other words, your money becomes worth more and you can buy more goods and service with it than before. The opposite of deflation is inflation, where the general prices of goods and service in an economy increase and your money is worth less than before.

Causes of Deflation

Deflation is directly related to the supply and demand of money. Keep in mind that the U.S. Dollar, like many currencies today, is a fiat money, which means it has absolutely no intrinsic value like gold or silver. Fiat money is valuable only because people are willing to use it, because the government promises that it has value - for example, the U.S. Dollar is backed by the 'full faith and credit' of the United States government.

Nevertheless, a government does not control the value of a unit of currency at any given time; instead the market determines the value. If demand for a product increases and the supply of it remains the same, then the price for the product increases. If the demand for a product decreases and the supply remains the same, then the price decreases. The price - or value - of money is no different.

Deflation occurs when the supply of money increases slower than the supply of goods and services we purchase with it. In this situation, there will be more demand for money than for goods and services. Prices will decline because money will be worth more as businesses will accept lower prices in order to get what money is out there. Moreover, if your money continues to rise in value faster than the cost of stuff you can buy with it, you are more likely to hold onto your cash, because by waiting, you figure you can buy even more a little later when your money is worth even more.

Effects of Deflation

You may think deflation sounds wonderful, and it certainly is nice for people who have a bunch of savings in cash, and for creditors because the money paid back to them is worth more than the value of the money they lent. However, on the whole, and in the long run, deflation can be very harmful for an economy and everyone in it. If deflation gets bad enough, an economy can enter into a deflationary spiral.

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