What Is Deflation and How Can it Be Prevented?

Q: There is currently talk in the media about the possibility of deflation. I think I understand what deflation is, and the problems that deflation would entail. However, I also seem to recall that when the government prints money it causes inflation. It seems to me, given these two "facts", the government would only have to print money to avoid deflation. (Pretty simple minded approach!)

Is the problem that there is more to printing money than printing money? Is in fact the way printed money gets into circulation, that the fed buys bonds, and thus gets money into the economy? What is the logical rabbit trail that leads to inflation from printing money? Would solving deflation this way work with today's low interest rates? Why or why not?

A: Deflation has been a hot topic since about 2001 and the fear of deflation does not look like it will subside anytime soon. Thanks for the topic suggestion!

What is deflation?

The Glossary of Economics Terms defines deflation as occurring "when prices are declining over time. This is the opposite of inflation; when the inflation rate (by some measure) is negative, the economy is in a deflationary period."

The article Why Does Money Have Value? explains that inflation occurs when money becomes relatively less valuable than goods. Then deflation is simply the opposite, that over time money is becoming relatively more valuable than the other goods in the economy. Following the logic of that article, deflation can occur because of a combination of four factors:

1. The supply of money goes down.
2. The supply of other goods goes up.
3. Demand for money goes up.
4. Demand for other goods goes down.

Deflation generally occurs when the supply of goods rises faster than the supply of money, which is consistent with these four factors. These factors explain why the price of some goods increase over time while others decline. Personal computers have sharply dropped in price over the last fifteen years. This is because technological improvements have allowed the supply of computers to increase at a much faster rate than demand or the supply of money. During the 1980's there was a sharp increase in the price of 1950's baseball cards, due to a huge increase in demand and a basically fixed amount of supply of both cards and money. So your suggestion to increase the money supply if we're worried about deflation is a good one, as it follows the four factors above.

Before we decide that the Fed should increase the money supply, we have to determine how much of a problem deflation really is and how the Fed can influence the money supply. First we'll look at the problems caused by deflation.

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