The government aims to maintain price level stability, by infusing money in the market to counterbalance the impact of deflation. However, low consumer spending due to lower money supply decreases demand; therefore, the supply of goods outpaces demand, causing depression in the economy. Furthermore, due to lower demand, unemployment tends to rise, as firms have to lay off workers. Other causes of deflation are the innovation that causes a sharp increase in productivity, thereby leading to lower prices and a change in the capital structure of markets that facilitates firms to raise capital to fund innovative production processes.
An example of deflation is the Great Depression in the United States that followed the US stock market crash in 1929. During the Great Depression, unemployment reached 25%, and although the output of high production industries such as mining and farming was high, workers were not compensated according to their labor. Therefore, consumer spending was extremely low, and people could not afford basic goods, no matter how low the prices were.
In a nutshell:
- Deflation is the general decline of the price level of goods and services.
- Deflation is usually associated with a contraction in the supply of money and credit, but prices can also fall due to increased productivity and technological improvements.
- Whether the economy, price level, and money supply are deflating or inflating changes the appeal of different investment options.