What is deflation and why is it important to avoid it?

Deflation (or negative inflation) is the opposite of inflation, i.e. a widespread and sustained decrease in prices in the economy. Although lower prices may seem like a good thing, deflation can in fact be highly damaging to the economy.

Deflation can lead to a vicious circle for the economy since it can drive down spending and investment, which in turn would lead to lower economic growth and higher unemployment.

Let us consider how deflation works: if you expect the price of a product – such as a car or a television – to decrease, you will delay the purchase until the price falls. If the belief that prices are going to fall persists over time and all consumers postpone their purchase decisions, companies will have to cut their prices due to the lack of sales. In addition, lower prices mean lower profits, which will force companies to reduce costs. They will therefore tend to lower employee wages or even lay off staff, thus driving up unemployment.

Unlike inflation, deflation makes it harder to repay debts because it increases the real debt burden (i.e. the value of debt in terms of the consumption basket). This could result in households and firms being unable to meet their payment obligations.

The European Central Bank’s (ECB) 2% inflation target over the medium term can provide something of a safety buffer to guard against deflation.