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Definition of Deflation:
is the decrease in the price level for goods and services and an increase in the value of money.
Economists fear deflation. Deflation is most common during severe recessions or depressions. When prices are falling, consumers may delay purchases goods and services hoping to pay less if they wait long enough. Why purchase something today when it will cost less tomorrow? Businesses may delay investing in equipment until the equipment prices fall and consumers resume purchasing their product. These behaviors discourage economic growth and may exacerbate a recession. This is why most economists favor moderate inflation to any deflation.
Deflation must not be confused with disinflation. Disinflation may be the desired result of monetary policy when a central bank wants to reduce the inflation rate. Disinflation is a slowing of the rate of inflation. Unlike deflation, prices continue to rise during disinflation - they just increase at a slower rate. Unlike deflation, businesses and consumers have an incentive to purchase in the present to avoid higher prices in the future.
To illustrate the distinction, assume in Year 1 the inflation rate equals four percent. Disinflation occurs if the inflation rate in year 2 is less than four but greater than zero. If the rate is less than zero, then the economy is experiencing deflation.
The graph shows that disinflation has been prevalent since 1980 because the price level has trended lower. Only briefly, in 2015, did we have deflation when the inflation rate dipped below zero.
Deflation occurred in the Great Depression when prices dropped approximately 30 percent. It took a war and over a decade for the United States to emerge from the depression. More recently, Japan experienced an extended period of deflation and severe recession in the 1990s. Japan still has not returned to the robust economy it had in the 1980s.
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