Deflation vs. Disinflation: What's The Difference And Why It Matters

Views 1245 Sep 26, 2024

When people hear the word inflation, it can make them think of rising grocery or gas prices. Along with this, deflation and disinflation are also economic factors that describe the average price level of goods and services in an economy over a period of time. Inflation is when prices increase; deflation is when prices decrease and disinflation occurs when the inflation rate falls but prices continue increasing. These terms are usually calculated as a percentage change from a previous period, such as a year earlier.

In this article, we'll focus on deflation and disinflation. Read on to learn more.

Deflation vs. disinflation: What's the difference

So what is disinflation vs deflation?

Dislinflation occurs when the inflation rate falls but remains positive, and prices continue to increase but at a slower rate. Disinflation is typically preferable to deflation because it is not disruptive to the economy.

Deflation occurs when the inflation rate falls below zero and prices generally decline across an economy. It can happen during bad economic times, like the Great Recession. While deflation can increase purchasing power and incentivize businesses to reduce costs, it can also lead to people postponing purchases.

What is deflation?

Deflation (or negative inflation) occurs when both consumer and asset prices decline over time, resulting in an increase in purchasing power. The same amount of money can buy more goods or services in the future compared to today. Deflation can often serve as a warning sign of an impending recession and difficult economic conditions. As consumers anticipate falling prices, they tend to postpone purchases, believing they can obtain better deals later. This reduction in spending reduces producers' income, potentially leading to higher unemployment and increased interest rates.

How is deflation measured?

Deflation is measured using economic indicators like the Consumer Price Index (CPI). The CPI tracks the prices of around 80,000 commonly purchased goods and services in the United States each month, including sales taxes and excise taxes. The CPI also includes sub-indexes that measure prices in different regions and cities.

When the prices measured by the CPI are lower in one period than in the previous period, the economy is experiencing deflation. Deflation is also known as negative inflation. It can be caused by a decrease in demand for goods and services, an increase in supply, or a lack of money supply.

What is disinflation?

The disinflation definition is a temporary decrease in the rate of inflation, or a slowing of the pace at which prices and wages increase. For example, if inflation slows from 8% to 6%, that indicates disinflation. During disinflation, prices and wages continuing increasing, but they rise more gradually than before.

Disinflation can also cause real interest rates to rise. For example, if someone earns 1% interest on their savings account, but the inflation rate is 3%, their real interest rate is -2%. This means they are losing purchasing power by keeping their money in a savings account at the current inflation rate.

Examples of deflation and disinflation

An example of when deflation occurred is the Great Depression. During this period, prices dropped an average of almost 7% each year between 1930 and 1933. This led to a collapse of many companies, rising unemployment, and a 33% drop in the wholesale price index between 1929 and 1933.

For disinflation, an example is from the early 1980s. According to the Federal Reserve Bank of St. Louis, the Fed cut monthly year-over-year inflation from March 1980's 14.6% to July 1983's 2.4%. However, unemployment also rose from 6.3% in March 1980 to 10.8% in November 1982 before falling back to 9.4% in July 1983.

How deflation can affect the stock market

Deflation can impact the stock market in a number of ways, including:

Decreased corporate profits: Can cause corporate profits to drop, which can lead to lower stock prices. This can have a ripple effect on some consumers who rely on stock appreciation and dividends for income.
Rising unemployment: Can lead to business failures and unemployment, which can reduce consumer purchasing power. This can cause prices, output, and demand to fall further, which can lead to a downward spiral.
Lower price/earnings ratio: As equity prices decline, the stock market can weaken further, which can be reflected by a dropping price/earnings ratio.

The causes of deflation

Some causes of deflation can include:

Decreased consumer demand: People may spend less if they are worried about the economy or unemployment.
Lower production costs: A decline in the price of key production inputs, like oil, can lower production costs. This can lead to an oversupply in the economy, and producers may need to lower prices to keep people buying.
Increased productivity: New technology can increase the number of products companies can produce for the same cost. This can lead to deflation if the market doesn't demand all the extra goods and services.
Shortage of money: A stagnant or slowly increasing amount of currency can cause deflation.
Increased debt: Deflation is linked with increased interest rates, which can increase the real value of debt. This can make consumers less likely to borrow money and spend

The effects of deflation

Positive effects

In the short term, deflation can help consumers buy more with the same amount of money, which can increase consumption and living standards. Moderate price drops for certain products, like food or energy, can also positively impact consumer spending.

Negative effects

Oversupply: When prices drop, businesses may produce more goods; this can lead to an oversupply of goods. It can also cause businesses to sell less, which can lead to job losses and lower profits.
Higher interest rates: Deflation can lead to higher interest rates.
Debt obligations: Extended deflation can make it difficult for consumers to pay back debts with money that's worth more than when it was borrowed.
Economic recession or depression: Deflation can intensify a recession or even lead to a deflationary spiral, which can eventually lead to an economic depression. Central banks often try to stop deflation as soon as it starts.

Has the U.S. experienced deflation?

Yes, as we previously mentioned, the Great Depression was a particularly dramatic example of deflation in US history. Between August 1929 and March 1933, the consumer price index and GDP deflator fell by 24%, and real GDP dropped by almost 30%. By the summer of 1929, the wholesale price index had fallen by 33%, and unemployment had peaked at over 20%.

The US has also experienced deflation during other periods, including: 1815–1860, 1865–1900, and 2007–2009.

Deflation vs. inflation

Deflation is when the price of goods and services decreases over time, and the purchasing power of money increases. This can also be caused by many factors, including an increase in productivity, a decrease in demand, or a decrease in the money supply. When deflation occurs, people can buy more with the same amount of money.

Inflation is when the price of goods and services increases over time, and the purchasing power of money decreases. This can be caused by a variety of factors, but it's usually sustained and affects most sectors of the economy.

FAQs about deflation and disinflation

Why is deflation so bad?

Deflation can be bad for the economy in a few ways:

Lower consumer spending: Deflation can make consumers wait to buy things because they expect prices to continue to fall. This can weaken the economy, which depends on steady consumer purchases.
Lower profits for businesses: When prices fall, companies make less profit, which can force them to cut costs. This can lead to layoffs, lower wages, and slower production, which can further lower demand and prices.
More expensive debt: Deflation makes it harder to repay debt because the value of debt doesn't decrease along with prices. This can lead to delinquencies and defaults, which can hurt lenders and make it harder for borrowers to get credit.

Is disinflation better than deflation?

Disinflation is generally considered to be better than deflation because it can help the economy function while deflation can be damaging:

When price increases slow down after a period of high inflation, disinflation is usually a positive development. It can indicate that the economy is slowing down and prices are not rising as quickly. For example, the U.S. experienced disinflation in the early 1980s when the inflation rate fell from 14.8% in 1980 to 3.2% in 1983.
When prices decline outright, deflation is typically a bad outcome for the economy. It can lead to a decrease in economic activity and job losses. For example, Japan experienced deflation in the late 1990s and early 2000s. Deflation can also increase the real value of debt, making it more difficult for borrowers to repay their loans. This can lead to defaults, foreclosures, and bank failures

Who benefits from deflation?

Deflation can benefit consumers in the short term, but it can have negative effects in the long term:

For consumers, when prices fall, the value of the dollar increases, which means consumers can buy more goods and services with the same amount of money. This can be especially helpful for people living on fixed incomes, like pensions or social security.

For people with saved money, when money is worth more, people who have money saved or set aside benefit.

How to react to deflation?

Here are some strategies that individuals can consider during periods of deflation:

Budget: Create a budget that focuses on necessities and savings, and consider deferring non-essential expenses.
Emergency fund: Build or replenish an emergency fund to help with financial stability during difficult times.
Invest: Diversify your investments to reduce risk. Consider government bonds, defensive stocks, dividend-paying stocks, and cash.
Reduce debt: Pay off debt to reduce financial commitments and improve your overall financial health.