A curious geek: What’s deflation?

08 May 2013

Recently I was reading the news and I realized that Greece now has Deflation, aka negative inflation. I was wondering what that means and as it happens, most of my friends work in the finance industry, so I asked them. Two of them just gave me a link from Wikipedia but I’m just too lazy to try and read those technical, complex terms. So my last remaining friend gave an answer that I’d like to share with the rest of the world.

I said, “when we have deflation with 5 pounds I can buy three cups of cappuccino, but when we have inflation I can buy a cup and a half. Why is deflation bad, it seems like I can buy more with the same money”. Here is his answer:

The real bank interest rate is: P = I(interest rate) – R(inflation). So when R(inflation) is negative (aka deflation), having your money in the bank is the best, risk free investment you can make. So people leave their money in the bank and they don’t do any kind of investments. That was still a bit complicated and boring. When an economy has deflation (I make it sound like a decease, but it is, kinda) your debt instead of inflating during time (aka has less value as the years go by) is getting bigger and bigger on top of interest! People borrow money, because, 100£ now is worth more than 100£ in 5 years. During deflation that’s not true, and as a result people are not borrowing any more, businesses are not borrowing any more, and inevitably the economy of a country is in stall. Also, in that economic climate, there are less chances to buy a house or any other goods, because the value of your investment is likely to fall due to deflation (money will worth more in due time, prices will likely fall). As a result of the above, the economy is frozen, no one borrows, no ones buys anything, everybody is waiting for the prices to drop and the life goes on like that. What’s worst is that businesses do not invest and therefor it’s less likely to create new jobs, so more unemployment. “That’s a vicious cycle for the economy”, said my friend Dimitris and he is right!

So that’s deflation people! Back to coding now….