What Is Deflation And Should You Be Concerned

Many of my clients (and me included) have been concerned about the expected rise of inflation. The problem is that we’ve been concerned for a few years and thus far, inflation has been a non-concern. What seems to be the new concern is deflation. Where deflation isn’t a typical concern for the average consumer, it has been a topic of concern for consumers and the Federal government at large for many years. Journalist Dave Carpenter refers to deflation as “Deflation is the potential new boogieman for consumers, replacing inflation.” So what exactly is this new boogieman? It is defined as the declining of prices of goods and services over time. Deflation is the direct opposite of inflation and occurs for one or more of the following reasons:

  • The supply of money decreases
  • The supply of other goods increases
  • The demand for money increases
  • The demand for other goods decreases

When Does Deflation Occur

Typically, deflation will occur when the supply of goods increases faster than the supply of money on hand. A good example of deflation can be explained using the advancement of technology. Years ago, personal computers cost a fortune because the technologies back then didn’t allow for an abundance of products to be on the market. Remember how much you paid for a computer 10 years ago? Over time, technology has advanced so much that the supply of computers increased at a faster rate than the demand for money, causing the prices of computers to drop drastically over the years. Now you can go to Wal-Mart and buy a mini laptop for a fraction of the cost.

Deflation is a natural part of the economy. When deflation occurs, the available amount of currency falls for each person, making money harder to come by but yet giving it more purchasing power. Consumers then pay less for goods and services. It may sound advantageous to get more power with every dollar but deflation also heightens the issue of debt because after a significant time of deflation, payments being made towards a debt represent an increased amount of money than when the initial debt was incurred.

The Bad Side of Deflation

There are a number of reasons to be concerned or at least aware of deflation. When consumers continually expect falling prices, they are less willing to spend or borrow money. This situation can depress the economy which allows the deflation cycle to continue. This leads to less jobs and a smaller cash flow for businesses and individual consumers. Additionally, deflation can spark higher interest rates, making credit less affordable and reduces activity and demand in the economy.

Should You Be Concerned About Deflation?

Worried about deflation
Creative Commons License photo credit: B Rosen

The symptoms of deflation can be a detrimental to an individual especially if they are left without a job and by definition have not traditionally been savers. Consumers are directly involved in the health of the US economy and when faced with a period of deflation, it is not solely the Federal government who must step in to the rescue. Spending money to stimulate the economy is just as necessary as the government’s responsibility to keeping money in stock.

During the Great Depression in the 1930’s, the Federal Reserve allowed the money supply to shrink by 35%. Consumers could not afford to buy products or services, and businesses could not sell what they were producing. Jobs were difficult to come by. The Federal Reserve is currently placing its focus on the declining demand for goods, the decrease in prices, and lowered wages. The government has not looked this closely at deflation since 2003 and there is concern we are not out of the woods just yet.

Disclaimer: Should you lose sleep worrying about deflation? Absolutely not. Deflation is just one of the many factors that could have an effect on your retirement nest egg. This is just another reason why you need to have regular meetings with your financial advisor to make sure that you make the necessary adjustments based on your situation.

sources:

http://www.msnbc.msn.com/id/38822584/ns/business-personal_finance/

Creative Commons License photo credit: James Jordan

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