Deflation : Cause & Effects

Although inflation has been the norm during the latter half of the 20th century, there were long periods in U.S. history during which prices actually fell - a phenomenon called deflation. In 1836, the money supply contracted by at least 30%; pushing prices down. Between 1875 and 1896, prices fell in the United States by 1.7% a year. Between 1930 and 1933, prices fell almost 10% a year. In 2008-9, the United States experienced the first deflation since the 1950s. Deflation is commonly defined as a general decrease in the price level. By that definition, it can be caused by a decreasing money supply, an increasing demand for money, a decreasing demand for goods, and/or an increasing supply of goods.

Many free marketers argue that deflation isn't necessarily something that should be feared. Price levels have steadily decreased in the past without leading to a Great Depression-style environment and the economy still grew. In fact, lower prices are often good for the consumer and a deflationary environment rewards savers.

Monetarists and Keynesians (and others who believe the economy can be managed) see deflation as a great scourge that must be stopped through monetary policies or government intervention. Inflating the currency is one management tool used by the Federal Reserve to do so. The Fed also can stimulate demand by lowering interest rates. However, once the Fed has lowered nominal interest rates all the way to zero, it is unlikely to be able to affect demand. If these low interest rates fail to stimulate the economy, monetary policy can become ineffective. This is called a liquidity trap.

As of 2009, the Fed has doubled the money supply in less than a year and lowered interest rates to almost zero in order to fight deflation. Time will tell whether or not it can succeed in its efforts.

When deflation strikes a credit-based economy (think cheap money), free marketers argue that normal business cycle rules simply do not apply. There is less money and credit available, which means people and companies often cannot maintain spending while continuing to meet their debt obligations. As corporate and personal incomes decline, defaults on debt begin to take place and then spread through the economy until the debt is literally flushed from the system. This process is inevitable and often takes many years to complete.