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When prices go down, it's generally considered a good thing—at least when it comes to your favorite shopping destinations. When prices go down across the entire economy, however, it's called deflation, and that's a whole other ballgame. Deflation is bad news for your country and your money.

Deflation definition

Deflation is when consumer and asset prices decrease over time, and purchasing power increases. Essentially, you can buy more goods or services tomorrow with the same amount of money. Compare this with inflation, which is the gradual increase in prices across the economy.

While deflation may seem like a good thing, it can signal an impending recession and hard economic times. When people feel prices are headed down, they delay purchases in the hopes that they can buy things for less at a later date. But lower spending leads to less income for producers, which can lead to unemployment and higher interest rates.

This negative feedback loop generates higher unemployment, even lower prices and even less spending. In short, deflation leads to more deflation. Throughout most of U.S. history, periods of deflation usually go hand in hand with severe economic downturns.

How is deflation measured?

Deflation is measured using economic indicators like the Consumer Price Index(CPI). The CPI tracks the prices of a group of commonly purchased goods and services and publishes the changes every month.

When the prices measured in aggregate by the CPI are lower in one period than they were in the period before, the economy is experiencing deflation. Conversely, when the prices collectively rise, the economy is experiencing inflation.

What causes deflation?

There are two big causes of deflation: a decrease in demand or growth in supply (lower costs of production). Each is tied back to the fundamental economic relationship between supply and demand. A decline in aggregate demand leads to a fall in the price of goods and services if supply does not change.

A drop in aggregate demand may be triggered by:

• Monetary policy: Rising interest rates may lead people to save their cash instead of spending it and may discourage borrowing. Less spending means less demand for goods and services.

• Declining confidence: Adverse economic events—such as a global pandemic—may lead to a decrease in overall demand. If people are worried about the economy or unemployment, they may spend less so they can save more.

Higher aggregate supply means that producers may have to lower their prices due to increased competition. This boost in aggregate supply may stem from a drop in production costs: If it costs less to produce goods, companies can make more of them for the same price. This can result in more supply than demand and lower prices.

Consequences of deflation

Although it may seem helpful for the price of goods and services to fall, it can have very negative effects on the economy.

• Unemployment: As prices drop, company profits decrease, and some companies may cut costs by laying off workers.

• Debt: Interest rates tend to go up in periods of deflation, which makes debt more expensive. Consumers and businesses often decrease spending as a result.

• Deflationary spiral.This is a domino effect caused by each overlapping piece of deflation. Falling prices may result in less production. Less production may lead to lower pay. Lower pay may result in a drop in demand. And a drop in demand may cause increasingly lower prices. And then the negative feedback loop continues. This can make a bad economic situation worse.