Deflation is the opposite situation of inflation. It is the situation where money value is rising and the price level is falling. But every fall in price cannot be deflation because sometimes it may occurs due to the operation of non-monetary causes like increasing return, over production, etc.
Deflation exists when the quantity of money in the economy is less than supply of goods and services. It is a disequilibrium situation, because along with fall in price level production and employment also fall. Through deflation the prices of commodities, the prices of factors of production and cost of production decrease. Therefore, we can say that common phenomenon of deflation is falling prices.
Deflationary trend may be set in either of the following two situations:
1. When the aggregate demand of goods and services falls.
2. When the supply of goods and services rises.
The main causes of deflation are –
(I) Increase in production- When the aggregate supply of commodities become greater than aggregate demand of commodities, this will lead to deflation. In this situation commodities remain unsold in the market. As a result firm reduce the price and production level of commodities and employment also decrease.
(II) Anti – inflationary measures- Deflation is the outcome of measures taken by the government to control inflation. There is a circle of price level changes in the economy and in course of controlling the price increase it may led to deflation in the economy.
(III) Money shortage- When the money supply is not sufficient to purchase of goods and services available in the country, the situation is known as deflation. Money shortage- may result of two factors (i) Note issuing authority decide not to increase money supply and (ii) the commercial banks may choose to conduct deposit and credit.
(IV) Fall in disposable income- Disposable income means income which use to purchase goods and services. A fall in disposable income will further shrink the money supply and will lead to deflation.
(V) Inflation- Inflation generates deflation- Inflation creates a state of over investment and over production in the economy which may push the price level downward in near future. This situation may discourage investment and production, which may result in falling profit margins. Any cut in investment and production programmes will breed deflationary forces in the country.
(VI) Government policy- The effects of government policies may also cause deflation. The secrets measures of credit control, high taxation, government’s borrowings and reduction in public expenditure may cause deflation in the economy.
So, it is clear that neither inflation nor deflation is good for economy.