What is deflation, and why do economists fear falling prices?
Falling prices sound like a bargain, yet central banks work hard to avoid them. Japan lived with them for decades.
is when the general level of prices falls, and economists fear it because it can feed on itself. Deflation occurs when the inflation rate falls below 0% and becomes negative. While inflation reduces the value of currency over time, deflation increases it. Falling prices can be harmless or even welcome when they come from efficiency gains: deflation also occurs when improvements in production efficiency lower the overall price of goods.
The trouble starts with debt and delay. Economists generally believe that a larger deflationary shock is a problem in a modern economy because it increases the , especially if the is unexpected. And when prices are falling, consumers have an incentive to delay purchases until prices fall further, which reduces overall economic activity. If that goes on, it can become a : lower prices lead to lower production, wages and demand, which lead to further falls in prices.
Step 1: Prices fall
Consumers see that tomorrow's price will be lower.
Step 2: People wait
They delay purchases until prices fall further.
Step 3: Output and wages drop
Lower demand leads to lower production, wages and demand.
Step 4: Prices fall again
The cycle feeds on itself.
Japan is the famous case, during the long stagnation known as the Lost Decades. started there in the early 1990s, and the Bank of Japan and the government tried to end it by reducing interest rates and , but did not create a sustained increase in broad money. Under deflation, Japanese companies cut wages, research and other investments and held on to cash instead.
The story has a late chapter: Japan's economy emerged from in the 2020s, partially due to the global inflation surge from 2021 to 2023.
Try it
Prices that fall every year
y = 1 · 0.9ˣ
Challenge · At a factor of 0.9, about what share of today's price level is left after 5 years? Now try 1.00 and 1.02.
Quiz me
0/3
Recap
Falling prices are not always good news: they make debts heavier and reward waiting, which can shrink the economy.
💡 A trick to remember it · If tomorrow's price is lower, everyone waits for tomorrow, and then nobody buys today.
Surprising fact · At 10% a year deflation, even an interest-free loan is unattractive because it must be repaid with money worth 10% more each year.
Connects to
- 🏦 What is a real interest rate, and how does Bank Rate reach savings and mortgages?
- 📉 Why did Japan's boom turn into the "lost decades"?
- 🎯 Why do central banks aim for about 2% inflation instead of zero?
- 🪙 Why did the countries that abandoned gold escape the Great Depression first?
- 💵 Why does money lose value over time?
Sources (2)
No source, no claim. Every fact in this lesson (16 claims) cites at least one of these.