There are two problems with understanding deflation: it is ill defined, and it has a bad name. This article puts deflation into its proper context. This is an important topic for advocates of gold as money, who will be aware that sound money, in theory, leads to lower prices over time and is often criticised as an objective, because it is not an inflationary stimulation.
The simplest definition for deflation is that it is when the quantity of money contracts. This can come about in one or more of three ways. The central bank may reduce the quantity of base money, commercial banks may reduce the amount of bank credit, or foreigners, in possession of your currency from an imbalance of trade, sell it to the central bank.
The link with prices is far from mechanical, because the most important determinant of the general price level is the relative appetite for holding money, and not changes of the quantity in issue, as the monetarists would have it. All else being equal, a deflation of the money quantity can be offset by a decline in the public’s desire for cash and deposits in hand, so that the general level of prices is unaffected.
Alternatively, a fall in the general price level can occur without a corresponding monetary deflation. This happens if a general preference for holding money increases. A further consideration is a population might collectively decide, based on increased uncertainty about the future perhaps, to hoard cash instead of leaving their savings in a bank. The resulting mismatch between production on the one side, and consumption (both immediate and deferred) on the other, caused by changes in physical cash withheld from circulation, can have a noticeable effect on prices.
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