What is Deflation?
Deflation means prices keep falling across the economy. It’s when the cost of most things goes down month after month.
Think of your weekly shopping. If deflation happens, that £100 shop might cost £97 next year. Then £94 the year after.
This is different from occasional sales or discounts. Sales are normal - shops reduce prices on some items for a short time. Deflation means prices fall everywhere - food, clothes, services. And they keep falling for months or years.
In the UK, the Bank of England has an inflation target of 2%. That means prices rise slowly and steadily. Low inflation means prices still go up, just more slowly. Deflation means prices actually fall. Your money buys more tomorrow than today.
While cheaper prices sound great, deflation causes big problems. If everybody reduces their spending, then companies earn less leading to lower wages and fewer jobs.
How Deflation Affects Your Daily Life
Impact on spending and saving
When prices drop on everything, consumers and businesses start to pull back on spending, waiting for even lower prices. Why buy a sofa today if it’ll be cheaper next month? This thinking spreads through the economy.
You might delay buying things you don’t need urgently. That new TV? Wait. Those home improvements? Put them off. But businesses need your spending to survive. When everyone waits, shops close and jobs disappear.
Your savings buy more as prices fall. That sounds good, but when everyone saves instead of spending, the economy shrinks even more.
Impact on debts
Your mortgage payment stays the same. You still owe £200,000 even if everything else costs less. Even if the interest rate on your debt goes down, the effective cost of the debt goes up.
Deflation increases the real burden of debt. Your £1,000 mortgage payment takes more of your spending power. The value of the debt does not change in nominal terms. But that debt feels heavier when your wages fall and prices drop.
Impact on jobs and wages
During deflation, businesses often cut costs by laying off staff and decreasing wages.
Businesses hire fewer people, and some close completely. In deflationary periods, firms are earning lower profits, and consumers are getting lower wages.
This creates the deflationary spiral: prices fall, people wait to buy things, businesses make less money, workers lose jobs or get pay cuts, people have even less to spend, prices fall more. This spiral can be very difficult to break.
Why Does Deflation Happen?
The main causes include a drop in overall spending. When people and businesses stop spending, prices fall. Shops cut prices to attract customers. This happened in the 1920s and 1930s. Due to contractionary fiscal and monetary policy, there was insufficient demand in the UK economy.
Sometimes better technology makes things cheaper to produce. This can push prices down. But this type of price fall is usually good. It’s different from harmful deflation.
Big events in the world can trigger deflation, such as wars ending and pandemics.
We’ve learned from history and central banks now actively work to prevent deflation.
How the Bank of England Prevents Deflation
The Bank of England prevents deflation by targeting 2% inflation rather than 0%.
The 2% target creates a safety buffer. It keeps the economy away from deflation while allowing prices to rise slowly. This encourages people to spend and invest normally.
The Bank Rate, which is set by the Bank of England, influences interest rates across the economy. When they lower rates, people spend more. When they raise rates, spending slows down.
When interest rates are already very low, they use quantitative easing. This means the Bank create new money electronically, use it to buy government bonds, and inject money directly into the economy. This increases the money supply and lowers long-term interest rates.
During deflation, the government can increase spending to stimulate the economy. Public projects like building roads, hospitals and schools create jobs. Workers then spend their wages, which helps the economy grow.
The Bank constantly track prices and demand across the economy. This helps spot problems early and take action when needed.
Summary
Deflation - when prices fall continuously across the economy - might seem appealing at first glance. After all, who doesn’t want their money to go further? But as we’ve seen, falling prices create serious economic problems.
When people expect lower prices tomorrow, they stop spending today. This waiting game spirals into business closures, job losses, and wage cuts. Meanwhile, debts become harder to repay as their real burden increases, even though the amount owed stays the same.
The good news is that we’ve learned from past deflationary periods like the Great Depression. Today, the Bank of England actively works to maintain gentle inflation at around 2%, creating a buffer zone that keeps deflation at bay. Through tools like interest rate adjustments and quantitative easing, combined with government spending when needed, our economy has safeguards against the deflationary spiral.
Understanding deflation helps explain why a small amount of inflation is actually healthy for the economy. It keeps money flowing, businesses operating, and people employed. While rising prices can feel frustrating, the alternative - a deflationary spiral - would be far worse for everyone.