What is deflation and why can falling prices be a problem for the economy?

Deflation is a sustained decline in the overall price level of goods and services in an economy. The key words here are "sustained" and "overall". If coffee goes on sale at a supermarket, that is not deflation. In this article, I'll explain why something that seems positive at first glance can actually cause serious damage to an economy.

Imagine that prices in shops gradually decline over a certain period. When you can buy more with the same amount of money, meaning that the purchasing power of money increases, that's deflation. To determine whether a country is experiencing deflation, statisticians analyse the cost of a consumer basket — a set of goods and services that households regularly purchase.

There are usually several causes, and they can overlap. These include:

• Weak consumer demand. People and businesses spend less because they are afraid of losing income or jobs.
• Excess supply. Production grows faster than market demand. Warehouses fill up, and sellers lower prices to clear their inventory.
• Productivity growth. New technologies reduce production costs, allowing companies to sell their products at lower prices.
• Tight monetary policy. When borrowing is expensive and the amount of money circulating in the economy decreases, people and businesses borrow and spend less. Demand weakens, putting downward pressure on prices.
• Cheaper energy and raw materials. When fuel or metal prices fall, products that use these inputs also become cheaper. Sometimes a stronger currency plays a role by reducing the cost of imports.

This is the distinction people most often misunderstand. Prices for individual categories of goods change constantly. Some vegetables become more expensive in winter, while others become cheaper in summer. Smartphones, televisions and computers have been getting cheaper per unit of computing power for decades. Yet the overall price level may continue to rise. These are changes in relative prices, and they are normal for an economy.

Deflation is different. It has two main characteristics:

1. Scale. Prices fall not just in one category but across a broad range of goods and services.
2. Duration. The decline continues for several consecutive quarters and appears to be a trend rather than a seasonal or one-off effect.

The main danger is that deflation can trigger a downward spiral. Here's how it works:

1. Prices fall, and people postpone purchases in anticipation of even lower prices.
2. Consumer demand weakens.
3. Businesses see sales declining and reduce prices even further.
4. Production contracts, wages are frozen or cut, and some employees are laid off.
5. Incomes fall, unemployment rises, and people become even less willing to spend.

As a result, economic activity weakens, and GDP may begin to decline.

For example, Japan experienced a prolonged period of deflation accompanied by weak economic growth. However, deflation was not the only cause of stagnation: the economy was also affected by the consequences of the asset price bubble collapse and problems in the financial system.

I should also point out something important: if prices fall because of productivity growth and new technologies, while incomes remain stable, the consequences are less severe. It is deflation driven by weak demand that is particularly dangerous.

This is where the consequences become most noticeable for individuals.

Nominal wages are rarely reduced openly because doing so is painful for both employees and companies. Instead, businesses usually respond by cutting staff or freezing pay increases. The result is rising unemployment and continued pressure on incomes.

This is perhaps the most dangerous channel. Debt denominated in hryvnias remains the same, while incomes in a deflationary economy decline. As a result, repayment becomes more difficult: the same instalment takes up a larger share of the budget. The real interest rate also rises because prices are falling while the nominal rate remains unchanged. Borrowers suffer, and banks face an increase in overdue payments.

Here lies a paradox. For an individual, savings may appear to benefit from deflation because money gains purchasing power.

In every country, the central bank is responsible for price stability. This does not mean that prices must remain unchanged. Its goal is to maintain inflation at a low, stable and predictable level, preventing both excessive price increases and prolonged declines in the overall price level. To achieve this, it uses monetary policy instruments.

In Ukraine, this responsibility belongs to the NBU. The regulator sets an inflation target at a certain level, and its main policy instrument is the key policy rate. This rate influences lending and deposit interest rates throughout the economy.

A typical set of measures to counter deflationary threats includes:

• Lowering interest rates. Cheaper loans encourage businesses and individuals to borrow and spend. Demand recovers, helping prices stabilise.
• Providing additional liquidity. The regulator can increase the amount of money available in the financial system to facilitate lending.
• Purchasing assets. Some central banks buy bonds and other assets to lower long-term interest rates and support the economy. This is an unconventional instrument used when interest rates are already close to zero.
• Communication. Clear signals about future monetary policy help adjust expectations: when people see that the central bank is ready to act, they become less concerned about falling prices.

These instruments have limitations. The scope for reducing interest rates is limited, particularly when they approach zero, making it necessary to seek other measures. That is why preventing deflation is easier than escaping it once it takes hold.

These are two opposite but related phenomena. Here's a brief comparison.

To conclude, moderate and predictable inflation is generally compatible with healthy economic development, while the consequences of deflation depend on the causes, scale and duration of falling prices.


Translation into English was created with the help of artificial intelligence.