Deflation

What Is Deflation?

Deflation is a general, sustained decrease in the overall price level across an economy - the opposite of inflation. Instead of the typical gradual rise in prices, a broad range of goods and services becomes cheaper over time. While falling prices might sound appealing to shoppers, economists generally regard sustained deflation as dangerous. It is distinct from disinflation, which is merely inflation slowing down while prices are still rising; deflation means prices are actually falling. The Fed's preference for a 2% inflation target rather than 0% is partly a deliberate buffer, meant to keep the economy a safe distance away from tipping into deflation.

Why It Matters

Deflation is dangerous because it can feed on itself. If households and businesses expect prices to keep falling, they may delay purchases and investment, which weakens demand and pushes prices down further - a self-reinforcing spiral that is hard to escape. Falling prices also raise the real burden of debt, since loans must be repaid in money that is now worth more. Deflation is especially difficult to fight because nominal interest rates cannot fall far below zero, blunting the Fed's main tool. This is a core reason the Fed aims for 2% inflation and keeps a buffer: a small positive rate of inflation leaves room to cut rates and steers clear of a deflationary trap.

Test Your Knowledge

Questions on this topic from the EconRecall fact bank:

• What is the term for a general, sustained decrease in the price level (the opposite of inflation)?
  Deflation
• Why does the Fed prefer a 2% target rather than a 0% target for inflation?
  It provides a buffer against deflation and room for interest rate cuts
• In AP Macroeconomics terms, what best describes the sustained decline in the general price level the U.S. economy experienced from 1929 to 1933?
  Deflation