However there are different types of deflation that have different implications. In other words, the effects of deflation depend to a large extent on the particular context. Thus it becomes quite obvious that deflation is a rather complex issue. To keep things simple we can distinguish between good deflation and bad deflation.
Good deflation
Good deflation is generally caused by a positive supply shock (i.e. an outward shift of the supply curve) that leads to the production of higher quantities sold at lower prices. In most cases, this type of deflation can be attributed to technological progress. New technologies allow companies to improve their production processes and reduce costs. As a result, the price level falls and (relatively speaking) money becomes more valuable.An example for good deflation is the development of flat screen televisions. When they were introduced a few years ago, not many people could afford to buy one, because they were quite expensive (3'000 $ - 4'000 $). However due to technological progress and improved production processes a flat screen television only costs about 600 $ - 1'000 $ these days.
This example illustrates why certain forms of deflation are considered "good". On one hand consumers obviously profit because they can afford to buy more things with the same amount of money, thus relatively speaking they become more wealthy. On the other hand suppliers can also profit from the deflation (even though prices fall) because they can reduce production costs simultaneously. This has to hold true because good deflation is triggered on the supply side.
Bad deflation
Bad deflation is caused by a negative demand shock (i.e. an inward shift of the demand curve) that leads to the consumption of lower quantities at lower prices. In other words, sellers have to reduce prices, because there is a lack of demand and they cannot sell their goods at the original price anymore. This is problematic in several ways:- When prices fall, people tend to postpone purchase decisions because they expect prices to fall even more. This can lead to a vicious circle, since postponed purchases result in lower demand which in turn drives prices further down.
- The burden of depts increases, as the price level decreases. That is, if you were to borrow money today, the amount you would have to pay back in a year would be worth more. Admittedly, the lenders profit from this situation. However, since they will usually only spend a portion of the additional income, this situation will lead to an additional decrease in overall spending (and thus amplify the vicious circle mentioned above).
- As a result of the lower revenue, companies will have to reduce costs. Because of sticky nominal wages (i.e. the fact that wages cannot be lowered without provoking resistance), companies will have to let people go, thereby causing an increase in unemployment.
To illustrate this we can look at the financial and economic crisis in 2008. The burst of the "housing bubble" in the United States combined with several other factors (easy loans, questionable business practices, etc.) caused prices to fall significantly within a very short amount of time. As a result, trillions of dollars of value were destroyed and both investors and consumers became increasingly cautious and restrained. However this exacerbated the situation, resulting in a vicious circle.
The example above illustrates why most forms of deflation are considered "bad". At a first glance it may look like consumers are better off. However, there are significant negative effects on suppliers that will eventually affect consumers as well. This form of deflation is especially problematic, because of the self-amplifying nature of the process that can ultimately lead to a deflationary trap.
