What is deflation?

Falling prices aren’t always the bargain you would hope.
This page was last updated on 10 January 2019

Imagine a world where the price of things kept going down… sounds great, right? This is called ‘deflation’. But it’s not all it’s cracked up to be.

To buy or not to buy?

What would you do if you knew the £100 bike you wanted to buy today, was going to be reduced to £90 tomorrow? You would probably wait to buy it for the cheaper price. When prices begin to fall, people expect they will continue to go down. This expectation results in people spending less today, in hope of buying at a cheaper price tomorrow. This is bad for businesses.

If prices fall, businesses are likely to make less profit. Businesses don’t like to see their profits fall, so they will try to do something about it. Let’s go back to that bike you wanted to buy. The owner of the bike shop is now getting £10 less for each bike and so may try to cut costs to make up for this loss.

This is where deflation can negatively affect employees. Businesses’ biggest cost is usually staff. To reduce staff costs, businesses have two options: to cut wages or staff numbers. In other words, deflation could lead to you losing your job.

If prices fall on a large scale, then there may be many job losses. People typically spend less when their incomes fall, so they might not be able to afford the bike at £90. So now, the business could be forced to cut prices further in order to sell anything at all. This creates a spiral effect as prices need to be reduced again and with falling income, comes unemployment if businesses can no longer afford to keep workers.

This spiral of falling prices and unemployment is often associated with a recession.

If prices fall… does my debt?

No – in fact, the opposite happens.

Many people have some sort of debt – a mortgage, a student loan or a credit card. Deflation can make it more expensive to repay your debts. Regardless of the general prices for goods and services, the amount of money you owe remains the same.

If you borrow £100 to buy your bike today but prices fall, you will still owe £100 tomorrow. This means you are effectively spending more money than the bike is now worth.

Now say you bought a house and its value dropped by £10,000, but you are still paying off the mortgage. Even though the house isn’t worth its original value, you still have to pay the same amount. This is bad news when you think about all the other things you could have spent that £10,000 on…

Of course there’s nothing wrong with occasional offers. There are also plenty of examples where prices fall as technology advances (imagine how much a computer would have been worth 50 years ago, when almost no one else had one) but there are more consequences from falling prices than meets the eye.

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