Deflation, in simple terms, is a general decline in prices of good and services. Since you are able to buy more from your 100 dollar bill than before, purchasing power of your money goes up.
Deflation, is the mirror image of inflation and is measured the same way inflation is, typically using the Consumer Price Index.
How does Deflation Affect Us?
At face value, deflation might seem like a good thing, particularly for consumers, as they can purchase the same good or service, spending lesser. However, for the economy as a whole, this might not be a good indication. When prices of goods begin to fall, consumers might hold off buying goods and services, in the hope that prices would fall further. However, this can lead to lower production levels. If production goes down, employment levels will also subsequently fall. With this, the economy might enter difficult times of slower growth.
Deflation is also bad for borrowers. Think of this. Before deflation, a I had borrowed $1000 form a friend, with a promise to return this amount after an year. With this $1000 I was able to buy an ipad. An year later, when it is time to return the borrowed amount, the economy is facing deflation. This $1000 that I’m returning now, would be able to buy an ipad along with a pair of Apple Earbuds. Thus, I (the borrower) am paying back money that is worth more than the money I had borrowed.
What Causes Deflation?
Deflation essentially happens when there is mismatch between demand and supply such that aggregate demand is much lower than aggregate supply.
One reason for this could be tighter money supply. To tighten the money supply in the economy, the central bank uses various tools that it hopes will translate into an increase in the interest rates on savings. When this happens, people would like to invest their money, rather than spending it. This leads to a reduction in overall demand for good and services and tends to bring the prices down. If this decline in demand, is not met with a proportionate decrease in supply of goods and services, the economy will tend to face deflationary pressures.
Other possible reasons include a recession, when the consumer confidence on the economy falls and they prefer to have savings rather than spend them.
Deflation might also happen when there is a sudden increase in production, which is not matched by an equivalent increase in demand. This sudden increase in production could be due to a drop in the price of an important input of production or due to technological advancements.
Example of Deflation
The most recent example of deflation in the US history is when the rate of inflation fell below 0% in 2009, after The Great Recession. See the graph below for monthly deflation levels in US in 2009. This was primarily driven by a significant drop in oil prices.