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.

The debate is currently raging over whether or not the United States faces a future of deflation or inflation. Learn about deflation in this section. To learn about inflation, click here.

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George Selgin is a professor of economics in the Terry College of Business at the University of Georgia, as well as a senior fellow at the Cato Institute and an associate editor of Econ Journal Watch. Selgin and his associates, Kevin Dowd and Lawrence H. White, founded the Modern...

Dr. Lacy H. Hunt is the executive vice president of the Austin, Texas-based firm Hoisington Investment Management. He was formerly the chief U.S. economist for one of the world's largest banks. In this interview, between Hunt and Business Spectator's...

Mish Shedlock is a registered investment advisor representative for Sitka Pacific Capital Management and a contributing "professor" to the site Minyanville. Time rated his blog in the Top 25 of Financial Blogs in 2009.

Mish writes, "Deflation properly defined is a net decrease in the money supply and credit, with credit being marked to market. Deflation...

Inflation, the author argues, is bad, but deflation is worse. It is undermining the financial system and deepening the recession. In America, Britain, Japan, and Switzerland, central banks are on the case, cutting interest rates and expanding their balance sheets. That said, the...

Matthew Lynn is a columnist for Bloomberg News and a regular contributor to the Spectator. In this article, Lynn claims that deflation poses no threat. He even suggests that a period of sustained deflation can put an indebted economy back on track. Deflation, he says, is good...

In the latter half of the twentieth century, Rothbard established himself as the principal Austrian economist. Rothbard's influence ranged far beyond economics; he helped shape and define modern libertarianism. In this article, Rothbard rallies against fiat money and interventionist government policies. Free...

Robert J. Shiller is the Arthur M. Okun Professor of Economics at Yale University and a fellow at the International Center for Finance, Yale School of Management. Among other things, he has written on financial markets, on real estate, and on public attitudes towards markets. In this...

James Bullard is the President and Chief Executive Officer of the Federal Reserve Bank of St. Louis. Bullard holds a Bachelor of Science degree in quantitative methods and information systems and economics from St. Cloud State University, and a doctorate in economics from Indiana...

John H. Makin specializes in international finance and financial markets. He is a visiting scholar at AEI. In this article, Makin argues that it is better to risk higher inflation than it is to risk an episode of deflation. He examines three past crises - the Great Depression of the 1930s, the...

Ebeling, the former president of Foundation for Economic Education, compares the current economic crisis to the Great Depression. He examines the monetary policies leading up to both crises, the thinking of the monetarists and Keynesians, as well as the results of those policies.

Here's an excerpt:...

Narayana Kocherlakota serves as chair of the economics department at the University of Minnesota. His current research includes financial economics, public finance and monetary economics. In this article, Kocherlakota argues for a nominal interest rate of zero. Interest...

Steven Levitt is the William B. Ogden Distinguished Service Professor of Economics at the University of Chicago, director of the Becker Center on Chicago Price Theory, and co-editor of the Journal of Political Economy. In 2003, he was awarded the John...

"Both bank credit and the M3 money supply in the United States have been contracting at rates comparable to the onset of the Great Depression since early summer, raising fears of a double-dip recession in 2010...

"Deflation is falling prices.

When prices fall at your local Walmart, it seems like a good thing.

But when it happens to your economy as a whole, it's trouble.

The problem is that economy-wide deflation takes no prisoners. Not only does the price of groceries go down, so does the value of most other assets including stock portfolios and home values.

...

Chart or Graph

The data suggests that there is no empirical link between deflation and depression.

This table shows the percent change in real gross domestic product from quarter to quarter between 2007 and 2009.

This graph, in particular, shows the annual rate of CPI change since 1913. It helps to put the current deflation in context.

Chart 1.6 from each year's report shows the percent increase in both CPI inflation and in core inflation between January 2000 and November 2008.

In other words, the economy was shrinking (deflating) during this period if one strips out debt-enabled spending by the federal government.

This graph, which was published by the research division of the Federal Reserve Bank of St. Louis, shows how the monetary base has grown and expanded between January, 1918 and July, 2009.

"The real problem is that the economy remains mired in a debt-deflationary cycle from which the only way out is through paying down the debt."

Analysis Report White Paper

Michael Bordo is a professor of economics at Rutgers University, New Brunswick. His primary research interests include monetary and financial history. Olivier Jeanne teaches economics at John Hopkins University. He is a research fellow at the Center for Economic Policy Research (CEPR, London) and a...

Andrew Atkeson is the Stanley M. Zimmerman Professor of Economics and Finance at the University of California, Los Angeles and a consultant to the Federal Reserve Bank of Minneapolis. This paper is the fruit of an extensive and broad historical study of inflation and real output growth rates. The...

Jorg Guido Hulsmann is a professor of economics at the University of Angers in France. Hulsmann is an anarcho-capitalist and one of the leading modern-day proponents of the Austrian School of Economics. In this short essay, Hulsmann argues for a free market in money and finance. He tackles...

Michael Bordo is a professor of economics at Rutgers University, New Brunswick. His primary research interests include monetary and financial history. Andrew Filardo is the Senior Economist at the Bank for International Settlements. In this paper, Bordo and Filardo conduct a broad, cross-country analysis of deflation...

John Brian Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University and a Senior Fellow at the Hoover Institution. He is an expert on monetary policy. Taylor has also been active in politics. He was a member of the Council of Economic Advisors during the Ford and...

"Monetary policy is the subject of a lively controversy between two schools of economics: MONETARIST and KEYNESIAN. Although they agree on goals, they disagree sharply on priorities, strategies, targets, and tactics. As I explain how monetary policy works, I shall discuss these disagreements. At the outset I disclose that I am a Keynesian.

Common Goals

Few...

This paper examines what happens as inflation declines toward zero. To do so, the authors study what happened after the Japanese asset price bubble catastrophically collapsed in 1991. They conclude that when inflation and interest rates have fallen close to zero, the government can...

"In this paper we review the history of deflation in China, Japan, and the United States, and summarize the stylized empirical facts regarding deflation and key real and monetary variables in these economies. Based on a review of the institutional background of deflation in these economies, we argue that deflation in China is largely supply-led, whereas deflation in Japan is demand-led. We...

"This paper investigates the response of industries to cyclical variations in demand in the context of a vintage model of 'creative destruction.' Due to process and product innovation, production units that embody the newest techniques are continuously being created, and outdated units are being destroyed. We investigate the extent to which changes in demand are accommodated on the creation or...

Video/Podcast/Media

"At a forum in Kansas City, Mo., Federal Reserve Chairman Ben Bernanke discussed the central bank's actions in handling the economic crisis, saying he did not want to be the Fed chief who 'presided over the second Great Depression.'"  At minute 25, Bernanke makes his statement.

John B. Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University and a Senior Fellow at the Hoover Institution. He is an expert on monetary policy. Taylor has also been active in politics. He was a member of the Council of Economic Advisors during the Ford and George H.W. Bush administrations. He also served as the Under Secretary of the Treasury from 2001 to 2005....

Mish presents his perspective on the current economic picture in a brief speech with a Q&A session. He approaches economics from an Austrian Economics perspective. He argues that the Federal Reserve purposefully promoted "cheap money" policies over the last several decades, which inflated various assets like houses, stocks, and commodities. He also argues that deflation has now set in, but...

Jorg Guido Halsmann is a professor of economics at the University of Angers in France. Halsmann is an anarcho-capitalist and one of the leading modern-day proponents of the Austrian School of Economics. He tackles conventional wisdom, claiming that, if we follow a hands-off policy, the economy will not be wiped out in a bottomless deflationary spiral. He admits that some deflation will...

Primary Document

Each year, the Chairman of the Council of Economic Advisors issues the Economic Report of the President, which details the nation's economic progress using text and data appendices. It reviews last year's economic activity, makes projections, and, based on the President's economic agenda,...

Whole speech below:

"Since World War II, inflation--the apparently inexorable rise in the prices of goods and services--has been the bane of central bankers. Economists of various stripes have argued that inflation is the inevitable result of (pick your favorite) the abandonment of...

Full Speech:

"Although the gold standard could hardly be portrayed as having produced a period of price tranquility, it was the case that the price level in 1929 was not much different, on net, from what it had been in 1800. But, in the two decades following the abandonment of the...

"Mises wrote this book for the ages, and it remains the most spirited, thorough, and scientifically rigorous treatise on money to ever appear. It made his reputation across Europe and established him as the most important economist of his age.

This classic treatise on monetary theory remains the definitive integration of microeconomics and macroeconomics. As Rothbard points out in his...

Nobel Laureate Milton Friedman hailed Irving Fisher as the "greatest economist that America ever produced." Irving Fisher was one of the earliest American neoclassical economists. Fisher made many important contributions to the Marginalist Revolution, including his debt-deflation theory. In this paper, Fisher...

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