Economists generally believe that a sudden deflationary shock is a problem in a modern economy because it increases the real value of debt, especially if the deflation is unexpected. Deflation may also aggravate recessions and lead to a deflationary spiral.^{[3][4][5][6][7][8][9]}

Deflation usually happens when supply is high (when excess production occurs), when demand is low (when consumption decreases), or when the money supply decreases (sometimes in response to a contraction created from careless investment or a credit crunch) or because of a net capital outflow from the economy.^[10] It can also occur due to too much competition and too little market concentration.^{[11][citation needed]}

In the IS–LM model (investment and saving equilibrium – liquidity preference and money supply equilibrium model), deflation is caused by a shift in the supply and demand curve for goods and services. This in turn can be caused by an increase in supply, a fall in demand, or both.

When prices are falling, consumers have an incentive to delay purchases and consumption until prices fall further, which in turn reduces overall economic activity. When purchases are delayed, productive capacity is idled and investment falls, leading to further reductions in aggregate demand. This is the deflationary spiral. The way to reverse this quickly would be to introduce an economic stimulus. The government could increase productive spending on things like infrastructure or the central bank could start expanding the money supply.

Deflation is also related to risk aversion, where investors and buyers will start hoarding money because its value is now increasing over time.^[12] This can produce a liquidity trap or it may lead to shortages that entice investments yielding more jobs and commodity production. A central bank cannot, normally, charge negative interest for money, and even charging zero interest often produces less stimulative effect than slightly higher rates of interest. In a closed economy, this is because charging zero interest also means having zero return on government securities, or even negative return on short maturities. In an open economy it creates a carry trade, and devalues the currency. A devalued currency produces higher prices for imports without necessarily stimulating exports to a like degree.

Deflation is the natural condition of economies when the supply of money is fixed, or does not grow as quickly as population and the economy. When this happens, the available amount of hard currency per person falls, in effect making money more scarce, and consequently, the purchasing power of each unit of currency increases. Deflation also occurs when improvements in production efficiency lower the overall price of goods. Competition in the marketplace often prompts those producers to apply at least some portion of these cost savings into reducing the asking price for their goods. When this happens, consumers pay less for those goods, and consequently, deflation has occurred, since purchasing power has increased.

Rising productivity and reduced transportation cost created structural deflation during the accelerated productivity era from 1870–1900, but there was mild inflation for about a decade before the establishment of the Federal Reserve in 1913.^[13] There was inflation during World War I, but deflation returned again after the war and during the 1930s depression. Most nations abandoned the gold standard in the 1930s so that there is less reason to expect deflation, aside from the collapse of speculative asset classes, under a fiat monetary system with low productivity growth.

In mainstream economics, deflation may be caused by a combination of the supply and demand for goods and the supply and demand for money, specifically the supply of money going down and the supply of goods going up. Historic episodes of deflation have often been associated with the supply of goods going up (due to increased productivity) without an increase in the supply of money, or (as with the Great Depression and possibly Japan in the early 1990s) the demand for goods going down combined with a decrease in the money supply. Studies of the Great Depression by Ben Bernanke have indicated that, in response to decreased demand, the Federal Reserve of the time decreased the money supply, hence contributing to deflation.

Demand-side causes are:

• Growth deflation: an enduring decrease in the real cost of goods and services as the result of technological progress, accompanied by competitive price cuts, resulting in an increase in aggregate demand.^[14]

A structural deflation existed from the 1870s until the cycle upswing that started in 1895. The deflation was caused by the decrease in the production and distribution costs of goods. It resulted in competitive price cuts when markets were oversupplied. The mild inflation after 1895 was attributed to the increase in gold supply that had been occurring for decades.^[15] There was a sharp rise in prices during World War I, but deflation returned at the war's end. By contrast, under a fiat monetary system, there was high productivity growth from the end of World War II until the 1960s, but no deflation.^[16]

Historically not all episodes of deflation correspond with periods of poor economic growth.^[17]

Productiv

When prices are falling, consumers have an incentive to delay purchases and consumption until prices fall further, which in turn reduces overall economic activity. When purchases are delayed, productive capacity is idled and investment falls, leading to further reductions in aggregate demand. This is the deflationary spiral. The way to reverse this quickly would be to introduce an economic stimulus. The government could increase productive spending on things like infrastructure or the central bank could start expanding the money supply.

Deflation is also related to risk aversion, where investors and buyers will start hoarding money because its value is now increasing over time.^[12] This can produce a liquidity trap or it may lead to shortages that entice investments yielding more jobs and commodity production. A central bank cannot, normally, charge negative interest for money, and even charging zero interest often produces less stimulative effect than slightly higher rates of interest. In a closed economy, this is because charging zero interest also means having zero return on government securities, or even negative return on short maturities. In an open economy it creates a carry trade, and devalues the currency. A devalued currency produces higher prices for imports without necessarily stimulating exports to a like degree.

Deflation is the natural condition of economies when the supply of money is fixed, or does not grow as quickly as population and the economy. When this happens, the available amount of hard currency per person falls, in effect making money more scarce, and consequently, the purchasing power of each unit of currency increases. Deflation also occurs when improvements in production efficiency lower the overall price of goods. Competition in the marketplace often prompts those producers to apply at least some portion of these cost savings into reducing the asking price for their goods. When this happens, consumers pay less for those goods, and consequently, deflation has occurred, since purchasing power has increased.

Rising productivity and reduced transportation cost created structural deflation during the accelerated productivity era from 1870–1900, but there was mild inflation for about a decade before the establishment of the Federal Reserve in 1913.^[13] There was inflation during World War I, but deflation returned again after the war and during the 1930s depression. Most nations abandoned the gold standard in the 1930s so that there is less reason to expect deflation, aside from the collapse of speculative asset classes, under a fiat monetary system with low productivity growth.

In mainstream economics, deflation may be caused by a combination of the supply and demand for goods and the supply and demand for money, specifically the supply of money going down and the supply of goods going up. Historic episodes of deflation have often been associated with the supply of goods going up (due to increased productivity) without an increase in the supply of money, or (as with the Great Depression and possibly Japan in the early 1990s) the demand for goods going down combined with a decrease in the money supply. Studies of the Great Depression by Ben Bernanke have indicated that, in response to decreased demand, the Federal Reserve of the time decreased the money supply, hence contributing to deflation.

Demand-side causes are:

Supply-side causes are:

• Bank credit deflation: a decrease in the bank credit supply due to bank failures or increased perceived risk of defaults by private entities or a contraction of the money supply by the central bank.^[20]

Debt deflation

Main article: Debt deflation

Debt deflation is a complicated phenomenon associated with the end of long-term credit cycles. It was proposed as a theory by Irving Fisher (1933) to explain the deflation of the Great Depression.^[21]

Money supply side deflation

From a monetarist perspective, deflation is caused primarily by a reduction in the velocity of money and/or the amount of money supply per person.

A historical analysis of money velocity and monetary base shows an inverse correlation: for a given percentage decrease in the monetary base the result is nearly equal percentage increase in money velocity.^[12] This is to be expected because monetary base (M_B), velocity of base money (V_B), price level (P) and real output (Y) are related by definition: M_BV_B

Debt deflation is a complicated phenomenon associated with the end of long-term credit cycles. It was proposed as a theory by Irving Fisher (1933) to explain the deflation of the Great Depression.^[21]

Money supply side deflation

From a monetarist perspective, deflation is caused primarily by a reduction in the velocity of money and/or the amount of money supply per person.

A historical analysis of money velocity and monetary base shows an inverse correlatio

From a monetarist perspective, deflation is caused primarily by a reduction in the velocity of money and/or the amount of money supply per person.

A historical analysis of money velocity and monetary base shows an inverse correlation: for a given percentage decrease in the monetary base the result is nearly equal percentage increase in money velocity.^{A historical analysis of money velocity and monetary base shows an inverse correlation: for a given percentage decrease in the monetary base the result is nearly equal percentage increase in money velocity.[12] This is to be expected because monetary base (M_B), velocity of base money (V_B), price level (P) and real output (Y) are related by definition: M_BV_B = PY.[22] However, it is important to note that the monetary base is a much narrower definition of money than M₂ money supply. Additionally, the velocity of the monetary base is interest rate sensitive, the highest velocity being at the highest interest rates.[12]}

In the early history of the United States, there was no national currency and an insufficient supply of coinage.^[23] Banknotes were the majority of the money in circulation. During financial crises, many banks failed and their notes became worthless. Also, banknotes were discounted relative to gold and silver, the discount depending on the financial strength of the bank.^[24]

In recent years changes in the money supply have historically taken a long time to show up in the price level, with a rule of thumb lag of at least 18 months. More recently Alan Greenspan cited the time lag as taking between 12 and 13 quarters.^[25] Bonds, equities and commodities have been suggested as reservoirs for buffering changes in money supply.^[26]

In modern credit-based economies, deflation may be caused by the central bank initiating higher interest rates (i.e., to 'control' inflation), thereby possibly popping an asset bubble. In a credit-based economy, a slow-down or fall in lending leads to less money in circulation, with a further sharp fall in money supply as confidence reduces and velocity weakens, with a consequent sharp fall-off in demand for employment or goods. The fall in demand causes a fall in prices as a supply glut develops. This becomes a deflationary spiral when prices fall below the costs of financing production, or repaying debt levels incurred at the prior price level. Businesses, unable to make enough profit no matter how low they set prices, are then liquidated. Banks get assets that have fallen dramatically in value since their mortgage loan was made, and if they sell those assets, they further glut supply, which only exacerbates the situation. To slow or halt the deflationary spiral, banks will often withhold collecting on non-performing loans (as in Japan, and most recently America and Spain). This is often no more than a stop-gap measure, because they must then restrict credit, since they do not have money to lend, which further reduces demand, and so on.

Historical examples of credit deflation

Although the values of capital assets are often casually said to deflate when they decline, this usage is not consistent with the usual definition of deflation; a more accurate description for a decrease in the value of a capital asset is economic depreciation. Another term, the accounting conventions of depreciation are standards to determine a decrease in values of capital assets when market values are not readily available or practical.

Historical examples

In February 2009, Ireland's Central Statistics Office announced that during January 2009, the country experienced deflation, with prices falling by 0.1% from the same t

In February 2009, Ireland's Central Statistics Office announced that during January 2009, the country experienced deflation, with prices falling by 0.1% from the same time in 2008. This is the first time deflation has hit the Irish economy since 1960. Overall consumer prices decreased by 1.7% in the month.^[43]

Brian Lenihan, Ireland's Minister for Finance, mentioned deflation in an interview with RTÉ Radio. According to RTÉ's account,^[44] "Minister for Finance Brian Lenihan has said that deflation must be taken into a

Brian Lenihan, Ireland's Minister for Finance, mentioned deflation in an interview with RTÉ Radio. According to RTÉ's account,^[44] "Minister for Finance Brian Lenihan has said that deflation must be taken into account when Budget cuts in child benefit, public sector pay and professional fees are being considered. Mr Lenihan said month-on-month there has been a 6.6% decline in the cost of living this year."

This interview is notable in that the deflation referred to is not discernibly regarded negatively by the Minister in the interview. The Minister mentions the deflation as an item of data helpful to the arguments for a cut in certain benefits. The alleged economic harm caused by deflation is not alluded to or mentioned by this member of government. This is a notable example of deflation in the modern era being discussed by a senior financial Minister without any mention of how it might be avoided, or whether it should be.^{[45][original research?]}

Deflation started in the early 1990s.^[37] The Bank of Japan and the government tried to eliminate it by reducing interest rates and 'quantitative easing', but did not create a sustained increase in broad money and deflation persisted. In July 2006, the zero-rate policy was ended.

Systemic reasons for deflation in Japan can be said to include:

• Tight monetary conditions. The Bank of Japan kept monetary policy loose only when inflation was below zero, tightening whenever deflation ends.^[46]
• Unfavorable demographics. Japan has an aging population (22.6% over age 65) that is not growing and will soon start a long decline. The Japanese death rate recently exceeded its birth rate.
• Fallen asset prices. In the case of Japan asset price deflation was a mean reversion or correction back to the price level that prevailed before the asset bubble. There was a rather large price bubble in stocks and especially real estate in Japan in the 1980s (peaking in late 1989).
• Insolvent companies:  Banks lent to companies and individuals that invested in real estate. When real estate values dropped, these loans could not be paid. The banks could try to collect on the collateral (land), but this wouldn't pay off the loan. Banks delayed that decision, hoping asset prices would improve. These delays were allowed by national banking regulators. Some banks made even more loans to these companies that are used to service the debt they already had. This continuing process is known as maintaining an "unrealized loss", and until the assets are completely revalued and/or sold off (and the loss realized), it will continue to be a deflationary force in t

  Systemic reasons for deflation in Japan can be said to include:

  In November 2009, Japan returned to deflation, according to the Wall Street Journal. Bloomberg L.P. reports that consumer prices fell in October 2009 by a near-record 2.2%.^[49]

  United Kingdom

  During World War I the British pound sterling was removed from the gold standard. The motivation for this policy change was to finance World War I; one of the results was inflation, and a rise in the gold price, along with the corresponding drop in international exchange rates for the pound. When the pound was returned to the gold standard after the war it was done on the basis of the pre-war gold price, which, since it was higher than equivalent price in gold, required prices to fall to realign with the higher target value of the pound.

  The UK experienced deflation of approx 10% in 1921, 14% in 1922, and 3 to 5% in the early 1930s.^[50]

  United States

  

  Annual inflation (in blue) and deflation (in green) rates in the United States since 1666
  

  US CPI-U starting from 1913; Source: U.S. Department Of Labor

  Major deflations in the United States

  There have been four significant periods of deflation in the United States.

  The first and most severe was during the depression in 1818–1821 when prices of agricultural commodities declined by almost 50%. A credit contraction caused by a financial crisis in England drained specie out of the U.S. The Bank of the United States also contracted its lending. The price of agricultural commodities fell by almost 50% from the high in 1815 to the low in 1821, and did not recover until the late 1830s, although to a significantly lower price level. Most damaging was the price of cotton, the U.S.'s main export. Food crop prices, w

  During World War I the British pound sterling was removed from the gold standard. The motivation for this policy change was to finance World War I; one of the results was inflation, and a rise in the gold price, along with the corresponding drop in international exchange rates for the pound. When the pound was returned to the gold standard after the war it was done on the basis of the pre-war gold price, which, since it was higher than equivalent price in gold, required prices to fall to realign with the higher target value of the pound.

  The UK experienced deflation of approx 10% in 1921, 14% in 1922, and 3 to 5% in the early 1930s.^[50]

  United States[50]

  There have been four significant periods of deflation in the United States.

  The first and most severe was during the depression in 1818–1821 when prices of agricultural commodities declined by almost 50%. A credit contraction caused by a financial crisis in England drained specie out of the U.S. The Bank of the United States also contracted its lending. The price of agricultural commodities fell by almost 50% from the high in 1815 to the low in 1821, and did not recover until the late 1830s, although to a significantly lower price level. Most damaging was the price of cotton, the U.S.'s main export. Food crop prices, which had been high because of the famine of 1816 that was caused by the year without a summer, fell after the return of normal harvests in 1818. Improved transportation, mainly from turnpikes, and to a minor extent the introduction of steamboats, significantly lowered transportation costs.^[24]

  The second was the depression of the late 1830s to 1843, following the Panic of 1837, when the currency in the United States contracted by about 34% with prices falling by 33%. The magnitude of this contraction is only matched by the Great Depression.^[51] (See: Historical examples of credit deflation) This "deflation" satisfies both definitions, that of a decrease in prices and a decrease in the available quantity of money. Despite the deflation and depression, GDP rose 16% from 1839 to 1843.^[51]

  The third was after the Civil War, sometimes called The Great Deflation. It was possibly spurred by return to a gold standard, retiring paper money printed during the Civil War.

  The Great Sag of 1873–96 could be near the top of the list. Its scope was global. It featured cost-cutting and productivity-enhancing technologies. It flummoxed the experts with its persistence, and it resisted attempts by politicians to understand it, let alone reverse it. It delivered a generation’s worth of rising bon

  The first and most severe was during the depression in 1818–1821 when prices of agricultural commodities declined by almost 50%. A credit contraction caused by a financial crisis in England drained specie out of the U.S. The Bank of the United States also contracted its lending. The price of agricultural commodities fell by almost 50% from the high in 1815 to the low in 1821, and did not recover until the late 1830s, although to a significantly lower price level. Most damaging was the price of cotton, the U.S.'s main export. Food crop prices, which had been high because of the famine of 1816 that was caused by the year without a summer, fell after the return of normal harvests in 1818. Improved transportation, mainly from turnpikes, and to a minor extent the introduction of steamboats, significantly lowered transportation costs.^[24]

  The second was the depression of the late 1830s to 1843, following the Panic of 1837, when the currency in the United States contracted by about 34% with prices falling by 33%. The magnitude of this contraction is only matched by the Great Depression.^[51] (See: Historical examples of credit deflation) This "deflation" satisfies both definitions, that of a decrease in prices and a decrease in the available quantity of money. Despite the deflation and depression, GDP rose 16% from 1839 to 1843.^[51]

  The third was after the Civil War, sometimes called The Great Deflation. It was possibly spurred by return to a gold standard, retiring paper money printed during the Civil War.

  The Great Sag of 1873–96 could be near the top of the list. Its scope was global. It featured cost-cutting and productivity-enhancing technologies. It flummoxed the experts with its persistence, and it resisted attempts by politicians to understand it, let alone reverse it. It delivered a generation’s worth of rising bond prices, as well as the usual losses to unwary creditors via defaults and early calls. Between 1875 and 1896, according to Milton Friedman, prices fell in the United States by 1.7% a year, and in Britain by 0.8% a year.

  — [52

  The fourth was in 1930–1933 when the rate of deflation was approximately 10 percent/year, part of the United States' slide into the Great Depression, where banks failed and unemployment peaked at 25%.

  The deflation of the Great Depression occurred partly because there was an enormous contraction of credit (money), bankruptcies creating an environment where cash was in frantic demand, and when the Federal Reserve was supposed to accommodate that demand, it instead contracted the money supply by 30% in enforcement of its new credit (money), bankruptcies creating an environment where cash was in frantic demand, and when the Federal Reserve was supposed to accommodate that demand, it instead contracted the money supply by 30% in enforcement of its new real bills doctrine, so banks toppled one-by-one (because they were unable to meet the sudden demand for cash – see fractional-reserve banking). From the standpoint of the Fisher equation (see above), there was a concomitant drop both in money supply (credit) and the velocity of money which was so profound that price deflation took hold despite the increases in money supply spurred by the Federal Reserve.

  Throughout the history of the United States, inflation has approached zero and dipped below for short periods of time. This was quite common in the 19th century, and in the 20th century until the permanent abandonment of the gold standard for the Bretton Woods system in 1948. In the past 60 years, the United States has only experienced deflation two times; in 2009 with the Great Recession and in 2015, when the CPI barely broke below 0% at -0.1%.^[55]

  Some economists believe the United States may have experienced deflation as part of the financial crisis of 2007–10; compare the theory of debt deflation. Year-on-year, consumer prices dropped for six months in

  Some economists believe the United States may have experienced deflation as part of the financial crisis of 2007–10; compare the theory of debt deflation. Year-on-year, consumer prices dropped for six months in a row to end-August 2009, largely due to a steep decline in energy prices.^{[citation needed]} Consumer prices dropped 1 percent in October 2008. This was the largest one-month fall in prices in the US since at least 1947. That record was again broken in November 2008 with a 1.7% decline. In response, the Federal Reserve decided to continue cutting interest rates, down to a near-zero range as of December 16, 2008.^[56]

  In late 2008 and early 2009, some economists feared the US could enter a deflationary spiral. Economist Nouriel Roubini predicted that the United States would enter a deflationary recession, and coined the term "stag-deflation" to describe it.^[57] It is the opposite of stagflation, which was the main fear during the spring and summer of 2008. The United States then began experiencing measurable deflation, steadily decreasing from the first measured deflation of -0.38% in March, to July's deflation rate of -2.10%. On the wage front, in October 2009 the state of Colorado announced that its state minimum wage, which is indexed to inflation, is set to be cut, which would be the first time a state has cut its minimum wage since 1938.^[58]