Deflation

The 'general price level' comprises the price of wages, consumption goods and services. Changes in the relative prices of goods and services do not indicate inflation or deflation: a shortage of any one good which results in a higher price will be compensated by lower prices in other goods.

As with inflation, there are economists who regard deflation as a purely monetary effect, when the monetary authority and the banks constrict the money supply, and there are those who believe that price deflation follows dramatic falls in business confidence, which may reduce economic output, and result in contraction wherein the quantity and velocity of money, i.e. the speed with which money is circulating. In recent years, economists have also started to use the term inflation and deflation in relation to assets (i.e. as a short-hand for price inflation or price deflation), such as stocks and housing (production goods).

During deflation, while consumers can buy more with the same amount of money, they also have less access to money (e.g., as wages, debt, or the return realized on sales of their products). Consumers and producers who are in debt, such as mortgagors, suffer because as their (money) income drops, their (money) payments remain constant. Central bankers worry about deflation, because many of the tools of monetary policy become ineffective as inflation drops below zero (deflation). Deflation may set off a deflationary spiral, where businesses slow or stop investing, because the investment risk is perceived as higher than just letting the money appreciate due to deflation. (The deflationary spiral is the opposite of the hyper-inflationary spiral.) Similarly, in deflation consumers have an incentive to delay consumption, which may contribute to the deflationary spiral.

Deflation is generally regarded as a negative in modern currency environments, because a deflationary spiral may cause large falls in GDP and take a very long time to correct.

Deflation should not be confused with disinflation which is a slowing in the rate of inflation, that is, where the general level of prices are increasing, but slower than before.

In monetary theory, deflation is defined in terms of a rise in the demand for money, based on the quantity of money available. The Quantity Theory of Money is founded on the Fisher equation (also called the equation of exchange),

MV = PT, [2]

where M is the money supply, V is the velocity of money, P is the average price level and T is the total number of transactions. The velocity of money, however, cannot be measured directly.[3]