Deflation: What is it, what causes it and how does it impact us?

A sketchnote explaining what deflation is, common causes of deflation and how it impacts us. Full text description below.

Deflation is the economic opposite of inflation. So what exactly is deflation and how does it impact us?

What is deflation?

Deflation is when the prices of goods and services fall and the value of the currency goes up. This means as consumers we get more for our money. In anyone’s book, getting more for your money is good, but there’s more to the story as we’ll see…

Common causes

Just like inflation, there’s no single cause of deflation, but common conditions include:

  • The supply of goods and services being greater than the demand. This means people are unable or unwilling to spend money on the products and services available to them. Or perhaps the market is flooded with so many products, that there are simply not enough people willing to buy them.
  • Interest rates increasing to a level where it becomes too expensive for consumers and businesses to borrow money to spend or invest. Higher interest rates instead make it more appealing for people to put their money into savings, where they’ll earn more money.

How deflation impacts us

I always thought deflation to be a relatively positive thing, based on the assumption that the price of goods and services reduces, meaning the general cost of living goes down.

However, the reality is more complex than this. 

When products and services become cheaper, there is less profit for businesses to reinvest in jobs and growth.

This leads to greater unemployment and less tax revenues, which in turn leads to less money being spent by consumers, government and business….

…. which in turn leads to even less investment, greater unemployment and even less tax revenues, which in turn leads to…. well you get the picture!

Also a combination of higher interest rates and the rising value of the currency, means borrowing becomes more expensive and debts effectively grow in value, which means they take longer to repay.

This lack of cheap credit further impacts consumer spending and business investment, again contributing to the deflationary spiral.

The perennial balancing act

Just as too much inflation has a highly negative impact on society, so too does too much deflation.

The utopia for government economists is a consistently low level of inflation that maintains growth, keeps the people (relatively) happy and slowly chips away at national debts.

Unfortunately the world does not work as simply as that, so I think it is more a case of being prepared to ride the waves of inflation and deflation as best we can.

Thanks for reading 🙂