Inflated Profits In A Deflated Economy

At first glance, deflation might seem like a dream come true.

After all, if it’s the opposite of inflation, and that means that prices drop…

That’s always awesome… right?

Not so fast. With those falling prices can come a number of potential pitfalls, including an unpredictable market and the risk of recession or even depression.

In this post, I’ll explain what deflation is, why it matters, and how it can affect the economy. And, of course, I’ll get into what you as a trader can do to stay on top of market changes during times of deflationary pressure.

What Is Deflation?

Deflation is a lowering of prices in the economy. Simple as that. If the overall cost goes down over a sustained period, it’s considered deflation.

But to really help you understand, let’s do a little visualization exercise.

Imagine you’re at the grocery store with a big ol’ basket. You put all sorts of things in it: some that you need and some that you want. Then, you head over to the register to pay.

When the clerk tells you the total, is it the same, lower, or higher than usual?

Sure, there can be natural variations — maybe yogurt was on sale this week, or you decided to go with the pricier organic chicken.

But week after week, month after month, is there a price trend in either direction?

To bring it back to deflation … let’s edit that exercise a little. Now, instead of chicken, yogurt, soda and other groceries, in your imaginary basket, its filled with things like consumer goods, transportation, medical care, and other big economic factors.

If the price of this basket — on average — drops in price for a sustained period … that’s deflation.

Deflation vs. Inflation

Deflation and inflation are basically the same, just opposites.

• Deflation is when prices in the economy decline. It’s actually sometimes even called “negative inflation.”
• Inflation is when prices in the economy increase.

Of course, inflation is a little trickier than that — to a certain degree, it’s inevitable. It’s when you have an extreme situation that things start to get sticky.

Deflation, on the other hand, might initially seem great (low prices, right?), but it can have effects that you may not have considered.

The Effect of Deflation on the Economy

Deflation represents prices going down. When you consider the long-term effects, though, it’s not always such a great thing.

Really, what’s happening is that prices are eroding because there’s lower demand. This can set off a series of unfortunate events: businesses start trying to compete by lowering prices. But over time, this can lead to trouble…

The increasing overhead and decreasing profit margins can mean that it’s harder to pay the bills.

If businesses can’t pay their bills, they can’t create products or continue to offer services.

Deflation Causes and Effects

So what causes deflation?

Supply and demand. Specifically: lots of supply and little demand.

So why is demand so low? It could be for a variety of reasons. One might be that there’s less money in circulation. When there’s less money, it’s worth more, so there’s less of a desire to use it on products. That leads to a reduction in prices and a glut of products.