Deflation is a decrease in the general price level of goods and services in an economy. Deflation can be caused by a reduction in the level of demand in the overall economy, or a reduction in the supply of money or credit.

The price level in an economy is affected by the level of aggregate demand (the sum of consumption, investments, government spending, and net exports) and aggregate supply.

If demand in the overall economy declines, whereas the supply of goods and services remains unchanged, this creates a disequilibrium in the market as there is now a surplus of goods and services.

This in turn puts downward pressure on the price level, causing deflation. Therefore periods of economic downturns or recessions are generally associated with an increase in unemployment and tend to lead to deflation.

Monetary policy – the management of interest rates and money supply in the economy – also affects the price level (see monetary policy). A deflationary monetary policy involves a decrease in the money supply and an increase in interest rates. A decrease in the money supply reduces the amount of money in circulation to be spent and invested. Higher interest rates encourages consumers to save money rather than spending it, and discourages investors from taking out loans to make investments. This decreases aggregate demand and leads to deflationary pressures.

Deflation can also be caused by tight credit. If credit supply among banks is scarce due to bank failures or increased credit risk, there may be a certain supply of money available to the economy but it will be hoarded by banks and won’t actually circulate in the economy.

The danger of deflation is that declining prices, if they persist, generally create a vicious spiral of negatives such as falling corporate profits, closing factories, shrinking employment and incomes, and increasing defaults on loans by companies and individuals.

Deflation is therefore dealt with by the central bank through a more expansionary monetary policy.

Above is the CPI for Japan since 2008. Japan is a typical example of an economy in deflation. After the speculative stock and property bubble burst in the 1990s, the Japanese economy stagnated, becoming trapped in a low-growth environment that led to a downward spiral of prices.

Deflation during this period was 1.97%. See also inflation.