Deflation happens when there is a decrease in the general prices. The prices can be of goods and services. This is exactly the opposite of what happens in inflation. In case of inflation there is a general increase in the prices. The value of money reduces in inflation and the value of money increases in case of deflation. This means that with the same amount of money, you can buy more goods and services at later period of time due to decrease in the prices.
Deflation can happen when there is reduction in spending either by government, personal spending or investment spending. It can happen when either of the following happens :
- Decrease in Money Supply
- Increase in supply of Goods or services
- Decrease in demand for goods or services
- Increase in demand for money
On the surface it appears that increase in value of money is a good thing. In fact it is good for those who are holding cash or for those who are creditors.
However, deflation is harmful as it can be damaging to the economy. It is damaging to the debtors and also has a negative impact on spending as investments are put to hold in case of falling prices for future spending. This is because the rising value of money creates an opportunity cost in spending it.
For example if you own Rs 1,00,000/- to the bank on a loan, and if you have the monies now, you can repay the amount today and be done with it. However if you make payments over the period of time in future and value of rupee is increasing you are losing out. Due to this businesses and people are loathe to borrow as they will face dual risk of interest and currency losses in future. This leads to less borrowing. This leads to impact across in housing markets, small companies as well as large organizations.
This creates a vicious cycle of less borrowing , less spending leading to decrease in economy, and increase in unemployment and can lead to deflationary spiral as in the case of Japan in 1990’s and 2000.
In case of Inflation, there is a threat to the growth to the real GDP of the economy due to rising prices and reduced spending. It has negative implications for employment and standard of living for everybody.
So, Deflation is equally harmful and damaging as inflation due to the reasons mentioned above.