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The current economic crisis has many experts talking about deflation. The concept of deflation can be a tricky one to understand because it has many causes and effects. Essentially, deflation is the opposite of inflation,  in that it is the decrease in the price of goods and services. Deflation is sometimes confused with “disinflation” in which the rate of inflation decreases (from 3% to 2%, for example). For deflation to occur, however, the inflation rate must fall below 0%.

Supply and demand for both money and goods affects price level. When the supply of money goes down and/or the demand for money goes up, deflation can occur. Conversely, when the supply of goods goes up and/or the demand for goods goes down, deflation can also occur.

To understand this concept, consider the current economic environment and the housing crisis. Prior to the burst of the housing bubble, easy access to credit meant there was large supply of money in the housing market. Consequently, there was a large demand for housing, and home prices rose at record levels. When the subprime industry collapsed and triggered a tightening in the lending market, the supply of money for housing went down. This, among other things, caused home prices to decrease, or deflate, in many areas of the country.

Some experts fear there is a genuine risk of economy-wide deflation because of the current economic situation. In October and November 2008, consumer prices fell 1% and 1.7% respectively. These were the two largest one-month declines since 1947. To help turn the tide on the downward consumer price trend, the Federal Reserve has cut interest rates to almost zero in an attempt to increase the supply of money in the market. It may be working as both January and February 2009 saw slight increases in consumer prices.

The two most famous instances of major deflation in U.S. history occurred after the Civil War and during the Great Depression. In the period after the Civil War, also called the “Great Deflation,” the government intentionally outdated the paper notes printed during the war. As money became worth less, employers were forced to cut wages. Additionally, borrower’s debts became worth more. The deflation of the Great Depression in the early 1930s was caused by a contraction of credit, much like the current economy. A wave of bankruptcies made the demand for money rise and there were runs on the banks. When banks couldn’t keep up with the demand for money, they collapsed. Between 1930 and 1933, the deflation rate was about 10% a year.

While many consumers think of prices going down on goods and services as a good thing, the problem is the spiral it creates. When prices go down dramatically, businesses earn less profit. Less profit translates into lower wages and job cuts. When consumers don’t have jobs or sufficient wages, they can’t afford to buy goods and services and the downward cycle continues.

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