Deflation in the Eurozone

  So most of us hear the word 'Inflation' thrown about on a regular basis, but 'Deflation' is more of a rarity. So what exactly is deflation? And should we be worried about potential deflation in the Eurozone?

     Deflation can be defined as the general decrease in the price level, and is thus simply the opposite to inflation. It means that the value of money is increasing and is often associated with periods of negative growth. Deflation caused by a rise in AS is more likely to be beneficial, as it indicates an increase in productivity. However, deflation brought about by falling AD can bring about many problems for an economy.(It must be pointed out that the mechanism for deflation is not as simple as a fall in AD)
     The first of these problems is that deflation often discourages consumption in an economy. Consumers delay spending with the expectation the prices wills continue to fall and as a result aggregate demand decreases even further.Therefore, periods of deflation often lead to lower consumer spending and lower economic growth, this in turn creates more deflationary pressure in the economy. Secondly, and perhaps the worst problem is the increase in the Real vaule of debt. Since most debts are fixed nominally, declining prices increase the real burden of the debt.

As prices decline, firms revenues decline while the service of the debt remains unchanged. This forces the private and public sectors to spend an increasing proportion of revenues to service the debt, forcing them to cut back their spending on goods and services. In addition , falling prices have a large impact on the housing market and as a result of falling asset prices, consumers lose confidence and consumption again falls.

    Recently there has been an indication of a risk of minor deflation  occuring in the EuroZone. Over the last ten years inflation expectations in the euro zone have been very close to 2%
However, inflation in the euro zone has been declining since early last year and now stands at 0.8%. This disinflation creates the potential for deflation. Germany’s inflation is 1.3% ,while inflation in , Ireland, Spain, and Portugal is 0.2 to 0.3% and in Italy 0.7%. However economists are not too concerned as Deflation is still very rare. Deflation usually only occurs during a prolonged and severe recession. It is a recession where demand falls significantly and eventually firms start to cut prices in a desperate attempt to boost spending.