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What does deflation mean?

Deflation is simply the opposite of inflation. Deflation means that prices of goods and services falls over time. It is usually measured by series like the CPI.

Deflation happens when we have a recession or depression. Because there is excess capacity in the economy, producers will try to create enough demand by reducing prices. Demand could also have fallen because incomes have fallen and money is not available for consumption expenditure. Consumption expenditure can also fall if the savings rate increases.

What seems to be happening in the present situation is that asset prices were driven up in a speculative boom. When that boom ended, asset prices fell. This caused a fall in capital spending which flowed through to lower output, lower incomes and therfore lower spending. People had also been saving less and spending it because asset growth in the boom was taking the place of saving. With less capital gain, they could not spend so much and also may have started to save again.

Deflation becomes a self-feeding cycle like inflation. Lower prices lead to even lower prices as everyone tries to keep output up. However, the lower prices flow through to lower profits, lower employment etc and lower spending and so on.

Governments can try to stimulate the economy through reducing interest rates. The idea is to make saving less attractive and spending more attractive. It may also tend to stimulate capital investment because of the lower cost of capital.

They can also try to stimulate the economy by spending more than they take in taxes and charges - run a deficit. It is hoped that this spending will stimulate spending and through the banking system create credit that leads to inflation again.

Since prices are generally on the move one way or the other - like stock markets - price stability is impossible. Prices tend to overshoot when they are rising leading to more inflation - and undershoot when they are falling - leading to more deflation.

So governments aim for low inflation and have set this as the objective for central banks in their use of monetary policy. The idea is that as prices start to rise out of a low inflation band, monetary and fiscal policy is used to dampen demand. As prices fall below the band, monetary and fiscal policy is used to try to stimulate demand.

That is the theory, but in practice an upward or downward self-feeding cycle can set in and it becomes very hard to stop it.