What Is Deflation?
A higher interest rate causes less spending, more saving, less borrowing from banks, and more loaning to banks. It acts to slow down our economic growth and may, if not regulated in time, lead to a recession. Such a period of economic slowing or stagnation is called a Contractionary Period, the opposite of a Expansionary Period or a period of economic growth.
Just as Expansionary Policies can overstimulate economic growth leading to increased levels of inflation, Contractionary Policies can slow the economy down to the point where GDP decreases and nobody’s buying anything because those high interest rates the banks are offering are too good to refuse. If the interest rates go high enough to become greater than the rate of inflation, if enough people have their money invested in these high-yield savings accounts, and/or if product sales become so anemic that their prices are lowered enough, deflation could result.
Whereas inflation is the case where your present $1 is worth more (“has more purchasing power”) than your $1 will have next year, deflation means today’s $1 will have more purchasing power next year than it does now. Deflation occurs only very rarely because the Fed and the government both have ways to counteract it. Something as simple as increasing the money supply can have the effect of decreasing a dollar’s purchasing power. More on that on another day.
- An example of deflation could be when most of the U.S. money supply is loaned to banks that offer a 10% APR while the rate of inflation is 4 or 5%.
- Deflation could also be when the consumer price index is at 1.0 this year but falls to .99 next year due to businesses across many industries deciding to reduce prices. What would cost $1 this year will cost $.99 next year.
- Usually deflation results from some sort of combination of the above two examples.
Deflation could theoretically also be artificially induced if the government decides to revalue our currency, for example deciding that all pennies will have the purchasing power of a dollar, nickels will have the purchasing power of five dollars, etc, increasing all of our net worth 100 times. This is clearly problematic because it would only solve some things in the very short term and then very likely lead to hyperinflation as everyone raced to raise prices to 100 times what they had been, leaving us right back where we started but possibly with an added problem of continued hyperinflation. It would also create massive problems for the indebted because their debt would now cost 100 times more.
Many communist countries, most notably China, regularly arbitrarily alter their money’s worth to give themselves the upper hand in the global economy. Most of the time, China’s revaluations involve keeping their currency’s worth tied to ours in a set proportion so that we cannot gain any economic benefits resulting from their currency dipping lower relative to ours. This has been a major point of contention between China and the Western nations for years now.