Deflation 101

As often as the term "inflation" is thrown around, you've probably heard the term "deflation" just as much as of late.

But what is deflation and how does it work?

Here's Deflation 101!

1/ Before you dive into deflation, it may be helpful to understand the basics of inflation.

Inflation is a measure of the rate of increase of the price of a basket of selected goods and services.

For a primer on inflation, check out my thread below. https://twitter.com/SahilBloom/status/1293590227064217603

2/ First, a few definitions.

Deflation is the decline in the price level of a basket of selected goods and services. It can be thought of as negative inflation.

It is typically expressed as a negative % and serves as an indicator of the increase in purchasing power of currency.

3/ The Consumer Price Index (CPI) and Wholesale Price Index (WPI) are the most common indexes for measuring inflation and deflation.

While typically discussed on an economy-wide basis, we may see deflation in certain areas of the economy and inflation in others.

4/ In very simple terms, deflation occurs when there is not enough money chasing too many goods.

This may occur from a contraction in money supply or credit (i.e. people are saving or banks aren't lending).

It may also occur from accelerated tech/productivity progression.

5/ To illustrate how this works, let's use a simple story.

Imagine the same primitive island society from our Inflation 101 example.

On this island, they use rare seashells as currency. There are only 1,000 seashells on the island.

The prices of goods are stable.

6/ An earthquake strikes the region, triggering a tsunami that washes over the island.

In the aftermath, the islanders find that 500 of the rare seashells (1/2 of them) have washed away.

There are now only 500 units of the currency, but the same amount of goods.

What happens?

7/ So what we have is a 50% decline in money supply and no change in the supply of goods.

Now there is too little money chasing the same amount of goods, so sellers of the goods lower their prices. Simple supply and demand.

This is deflation in action.

8/ The same dynamic may have occurred if producers of the goods had discovered new technology that allowed them to produce more efficiently.

The original 1,000 seashells would not have been able to keep up with the increase in goods.

(h/t @JeffBooth for @priceoftomorrow)

9/ The impact of the deflation differs across the two types of islanders.

Savers, who had stored seashells for later use, benefit as each stored seashell has become more valuable in its ability to purchase goods.

Asset Holders may see the value of their assets decline.

10/ Central bankers worldwide have a massive fear of deflation, so they target modest levels of inflation.

Why?

Deflation may incentivize saving over spending. If you believe your money will be worth more in purchasing power terms later, you are more likely to save it.

11/ Central bankers tend to ascribe to Keynesian principles, which focus on spending as a critical driver of growth.

In their minds, if deflation incentivizes saving, deflation is bad.

So they seek the "Goldilocks solution" - with a level of inflation that is just right.

12/ This view, it should be said, is highly-contested.

Given the current balance between the pandemic shock and the rapid increase in money printing, these debates have taken center stage.

It is important for everyone to understand the basics.

13/ This was a (very simple) primer on deflation. It is not intended to be exhaustive - there are certainly nuances to much of this.

I plan to continue to build upon this foundation in future threads.

That was Deflation 101! I hope you found it useful.

14/ For other educational threads on money, finance, and economics, check out my meta-thread below. Stay tuned for more! https://twitter.com/SahilBloom/status/1284583099775324161