Deflation occurs when the amount of currency in circulation is reduced and currency increases in its buying power. In short, the purchasing power of money increases. The inverse of inflation, under deflation it takes less money to buy the same amount of goods and services. Deflation may help consumers in terms of short-term affordability of goods and services in the market, but it has historically had an adverse macroeconomic impact on stock markets.
Historically, deflation is rare. In the United States, deflation of the 1930s led to the Great Depression and did not end until the country entered World War II. Japan also had a long deflationary period starting in the 1990s and continuing into the 21st century. In both instances, stock market values were devastated. In a deflationary economy, instead of reveling in bargains, consumers may become afraid to invest in depreciating products and services. They also anticipate prices falling even further, an additional incentive to delay purchases.
Commodities are generally a hedge against inflation, not deflation. When deflation occurs the value of cash rises. As a result, investment value in commodities such as precious metals -- historical safe-havens during an inflationary economy -- tends to decrease. The general principal reflected in the commodity markets is that value becomes a reflection of the depreciating value of the underlying product or service.
In a deflationary economy, companies may have to reduce prices for products and services. As a result, reduced profits may make loans that were perfectly good when originally made perfectly foolish. This is due to price and profit decreases for goods and services as well as the reduced value of collateral pledged for outstanding debt. Prices can fall to levels where companies, including publicly- traded ones, become insolvent and cannot afford to stay in business.
The demand for lending by investors and banks is reduced in a deflationary economy. Publicly-traded companies' assess to funding for worthwhile projects also tends to fall. Finance for innovation will suffer absent some type of purposeful actions to increase money circulation, such as through central bank actions related to the money supply and interest rates -- policies that are not always successful in reducing deflationary pressures.
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