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Understand economics at your own pace: step-by-step guided courses, and exercises to practice.
What is deflation?
When prices fall durably — and why that is not good news.
change in prices = (price_now − price_before) / price_before × 100Problem / motivation
Falling prices look like a good deal for consumers. So why are economists afraid of them?
We speak of deflation when the general price level — the average of what everything costs, not one isolated product — falls generally and durably. The problem: if everything will be cheaper tomorrow, you may as well wait before buying. When everyone postpones their purchases, firms sell less, cut their prices further… and the spiral sets in — you will take it apart piece by piece at the Interpretation step.
Assumptions
In your view, which assumptions are needed for this model to hold? Jot down your ideas — no lead is wrong, this is your worksheet.
Your worksheet is still empty. Go for it: propose at least one idea.
0 idea(s) proposedFormalization
Start from the shopping basket: €200 last year, €196 today. First the gap: 196 − 200 = −€4. But −€4 on a €200 basket or on a €20 tank of fuel is not the same matter — so we relate the gap to the starting point, −4 ÷ 200 = −0.02, then express it as a percentage: ×100, that is −2%.
This recipe — gap ÷ starting point × 100 — is nothing new: it is exactly the inflation rate π (“pi”, the economists' letter for Prices — nothing to do with the 3.14 of geometry) that the course “Inflation” builds on the CPI, the official price thermometer. When π is POSITIVE, prices rise: inflation. When it is NEGATIVE: deflation. One thermometer for both directions.
Careful: an isolated −2% does not make a deflation. The figure gives the DIRECTION of the change; the assumptions say the rest — the fall has to be GENERAL (the average level, not one product) and DURABLE (a trend, not one month). The formula measures; the assumptions qualify.
Hence the line in the header: change in prices = (price_now − price_before) ÷ price_before × 100. Negative, GENERAL and settled in: deflation. Click each term:
Solving / calculation
Let's take the basket from the formalisation again (€200 → €196) in three moves — then a fourth, decisive one: what €100 lying idle earns. Then try it yourself.
- Change in euros
196 − 200−€4 - Related to the starting price
−4 / 200−0.02 - As a percentage
−0.02 × 100change = −2% - And €100 kept under the mattress for a year? It faces lower prices — it buys MORE
100 / 0.98≈ €102.04 of purchasing power
A negative change (−2%): deflation IF the fall is general and settles in (assumptions 1-2). And look at the 4th computation: doing nothing pays (+2.04% of purchasing power without lifting a finger). Waiting becomes profitable — there is the fuel of the spiral that the next step takes apart.
change = (price_now − price_before) / price_before × 100Vary the price of the basket before and now: the change recomputes itself — and with it, what €100 kept idle is worth.
Economic interpretation
Why does a fall in prices alarm central banks — the ECB here, the institution that issues the currency and watches over prices? Because it can feed itself.
If the fridge will be cheaper in six months, I wait. Multiplied by millions of households: demand — the whole of purchases — collapses → firms sell less and cut their prices further → their profits melt away, wages frozen or trimmed, hiring stopped — even redundancies → incomes fall → people buy even less… and back to the first link, one notch lower. Each turn feeds the next: that is the spiral. Now look at WHAT it bites on: a fridge, a car, a machine — POSTPONABLE purchases (assumption 3). Nobody postpones their rent, their bread or their electricity. That is why the spiral eats away at demand without ever quite stopping it, and why it strikes DURABLE goods and investment first — the sectors where you can wait.
A debt is fixed in euros: it does not fall. If prices and incomes slide (the spiral above), the same debt weighs more and more in months of salary — exercise 5 has you put a number on it. The American economist Irving Fisher theorised it in 1933: “debt deflation”, the poison of great crises.
Its normal remedy when demand stalls: CUT its policy rate — the rent on money, which makes credit cheaper and revives purchases (course “The policy rate and transmission”). But once at zero, cutting further is all but impossible: the weapon runs out — Japan learned this, stuck for years with rates at zero. Hence the universal caution: aim for 2% inflation, never 0, so as to drive well away from the ditch (course “Inflation”).
Not every fall is an abyss: when prices fall because we produce BETTER (technical progress), the consumer grows richer without any spiral. The danger is a fall driven by collapsing demand — general, durable, self-sustaining. Diagnosing where a price movement comes from is the same art as for inflation (course “The causes of inflation”).
Limits / critiques
Exercises
A basket used to cost €250 and now costs €245. What is the change in prices (in %)?
In a deflation, why does the weight of a debt increase?
After YEARS of deflationary spiral, your monthly salary has gone from €1,250 to €1,000; your debt, meanwhile, has stayed fixed at €1,000. It used to represent 80% of a month's salary; it now represents… (in %)
True or false: in a deflation, falling prices can push unemployment UP.
Inflation goes from 5% to 1.5%. Is this deflation?
The price of televisions has been falling for twenty years thanks to technical progress, while the rest of the economy is ticking along nicely. Is this the deflation economists fear?
Prices fall by 2% a year. By keeping €100 under the mattress for a year, you will be able to buy…
Why does the ECB aim for 2% inflation rather than 0%?