Ask the Piggy Bank: What is Deflation?

I received this interesting question from a reader last night:

I’ve been hearing a lot about inflation lately. But now I’ve started to hear about deflation. What is deflation?

An excellent question! At its most basic, deflation is a fall in prices. It is the opposite of inflation. In the sense of this economy, deflation is most connected with the stock market and with housing prices — both of which are falling. (Consumer prices haven’t quite reached a state of deflation, so it’s not very helpful to household budgets.)

One of the biggest worries right now is that the economy will enter a deflation spiral. This is a great fear on the stock market, as there is a pullback in investment as  stock values (especially in the financial sector) fall. If you have a retirement account, or if you have stock investments that act as passive income, this sort of deflation is going to affect you.

Another concern is the continued fall in home values. As less equity is available in homes to provide support for spending, less spending happens. And this can create deteriorating economic conditions. Deflation also brings liquidity problems. Money does not flow as easily, and banks are not willing to lend to each other — or to you.

Inflation: the solution to deflation

As a result of deflation fears, the Federal Reserve authorized central banks around the world to release dollars into their economies (the Bank of Japan, for example, is now offering loans denominated in U.S. dollars) in order to increase liquidity. The idea is that by releasing more cash into the market, inflation will result in order to battle the deflation.

Don’t ask where the money for all this liquidity injection comes from, though. Because, basically, it comes from the promise of future returns on debts owed to the Federal Reserve. And some of it is, in fact, just being created out of thin air.

image source: Wikimedia Commons