Debt Deflation

Debt Deflation is also known as "worst deflation" and "collateral deflation".
Deflation is the opposite of inflation. Deflation means a decrease in the general price level. Deflation is term which was used by the classical economists to refer to a decrease in the money supply and credit. Deflation should not be confused with temporarily falling prices; instead, it is a sustained fall in general prices. In the IS/LM model (that is, the Income and Saving equilibrium/ Liquidity Preference and Money Supply equilibrium model), deflation is caused by a shift in the supply and demand curve for goods and interest, particularly a fall in the aggregate level of demand. That is, there is a fall in how much the whole economy is willing to buy and the going price for goods. Because the price of goods is falling, consumers have an incentive to delay purchases and consumption until prices fall further, which in turn reduces overall economic activity - contributing to the deflationary spiral. Here the investment in the different economies also falls, which contributes further reduction of demand. This situation can be controlled by generating demand in the market. This is done by bringing more money in the market or by reducing the lending rates. Here, the central banks and fiscal authorities play very important role in creating the favorable market condition.

Deflation is related to a sustained reduction in the velocity of money or number of transactions. This is attributed to a dramatic contraction of the money supply, perhaps in response to a falling exchange rate, or to adhere to a gold standard or other external monetary base requirement.

Deflation also occurs when improvements in production efficiency lower the overall price of goods. Improvements in production efficiency generally happen because economic producers of goods and services are motivated by a promise of increased profit margins, resulting from the production improvements that they make. Competition in the marketplace often prompts those producers to apply at least some portion of these cost savings into reducing the asking price for their goods. When this happens, consumers pay less for those goods; and consequently deflation has occurred, since purchasing power has increased.

While an increase in the purchasing power of one's money sounds beneficial, it can actually cause hardship when the majority of one's net worth is held in illiquid assets such as homes, land, and other forms of private property. It also amplifies the sting of debt, since-- after some period of significant deflation-- the payments one is making in the service of a debt represent a larger amount of purchasing power than they did when the debt was first incurred. Consequently, deflation can be thought of as a phantom amplification of a loan's interest rate.

Deflation is caused by a combination of the supply and demand for goods and the supply and demand for money, specifically the supply of (demand for) money going down (up) and the supply of (demand for) goods going up (down). Historic episodes of deflation have often been associated with the supply of goods going up (due to increased productivity) without an increase in the supply of money.