The fall in prices: Threat or opportunity for your economy?

The Essentials of Deflation

When we talk about deflation, we refer to an economic phenomenon where the prices of goods and services experience a widespread reduction. Although it sounds positive at first glance—your purchasing power increases and you can buy more with less money—the reality is more complex. Sustained deflation can bring serious consequences: rising unemployment, economic stagnation, and debt cycles that trap both individuals and businesses.

How does deflation arise?

Deflation does not appear out of nowhere. Generally, it responds to three main economic mechanisms:

Contraction of aggregate demand: When households and businesses significantly reduce their spending, the total demand for goods and services falls. Companies, faced with this lower number of buyers, have no choice but to lower their prices to maintain sales.

Excessive expansion of supply: Sometimes, production grows beyond what the market can absorb. New technologies that make manufacturing more efficient and economical can create this imbalance. When there is more product available than demand, prices inevitably fall.

Strengthening of the local currency: A strong currency allows for the purchase of more foreign products at a lower cost, which reduces import costs. At the same time, it makes national exports more expensive, reducing the number of international buyers interested. The result: downward pressure on domestic prices.

Deflation and inflation: two sides of the same coin

Although both talk about changes in overall prices, their dynamics are radically opposed:

In its definitions: Deflation represents a decrease in prices, increasing your purchasing power. Inflation is the opposite: prices rise, and your money loses value.

In its origins: Deflation arises from lower aggregate demand, greater supply, or technology that reduces costs. Inflation comes from higher demand than supply, elevated production costs, or expansive monetary policies that inject too much money into the economy.

In its economic sequels: During deflation, consumers delay purchases expecting lower prices, which slows down growth and increases unemployment. With inflation, people accelerate their purchases before prices rise further, generating demand but eroding the savings of those living on fixed incomes.

Mechanisms to Counteract Deflation

Governments and central banks have tools to combat deflation. In fact, many monetary authorities seek to maintain moderate annual inflation rates—typically around 2%—precisely to avoid falling into deflation.

Through monetary policy: Central banks can lower interest rates, making credit cheaper for businesses and consumers. Cheaper loans stimulate investment and spending. Another strategy is quantitative easing, which increases the amount of money in circulation, encouraging consumption.

Through fiscal policy: Governments can increase public spending to inject demand into the economy. They can also reduce taxes, leaving more money available in the pockets of families and businesses, encouraging them to invest and consume.

The case of Japan: a lesson on prolonged deflation

Japan represents the most documented example of low but persistent deflation in recent decades. This country experienced a “lost decade” where prices stagnated or slowly fell for years. Although consumers benefited from cheaper goods, economic growth slowed significantly, unemployment increased, and companies faced tighter margins. This case illustrates why, contrary to initial intuition, prolonged deflation is a problem that policymakers must actively avoid.

The Positive and Negative Faces of Deflation

The positive: Goods become more affordable, improving your access to products and services. Companies enjoy lower costs for raw materials. People tend to save more because their money retains or gains value.

The problematic: Consumers delay purchasing decisions, hoping for even lower prices. This postponement constricts demand, slowing growth. The value of debt increases, making it difficult for borrowers to pay off loans taken out years ago. Companies, facing lower revenues, respond with mass layoffs, fueling unemployment.

Final reflection

Deflation is a double-edged economic phenomenon. While it initially seems beneficial—your money buys more—its sustained consequences can be devastating. A widespread and prolonged reduction in prices discourages consumption, increases the burden of debt, and destroys jobs. That is why modern financial systems are designed to avoid deflation, seeking moderate inflation that keeps the economy dynamic and growing.