Deflation is a sustained reduction in the general price level across an economy or in a particular class of goods or services. This might sound like great news for the average consumer but in reality spells disaster for an economy because when prices are declining and expected to continue declining, few people have any motivation to engage in economic activity such as investing, borrowing, or even buying goods.
The causes of deflation can either be internal to an economy or come from outside of it. There may be a sharp fall in the price of economic inputs like energy which cause deflation across the economy, which is something that western economies are bracing for as we speak. In another scenario, if money becomes scarce within an economy because credit is expensive or the central bank restricts the supply, then prices can be expected to fall so that sellers can attract what little money there is in the economy.
A sharp decrease in aggregate demand due to high unemployment or a fall in disposable income can have the same effect, as prices are lowered to stimulate demand. Deflation can cause consumers to hoard their money rather than spending it because they know that tomorrow they will be able to buy more than they could today for the same amount of money. This can cause demand to fall further and drag prices down still further, contributing to what is called a "deflationary spiral". Usually savers are spurred to try and lend their money (or put it in a bank that does it for them, and gives them a rate of interest in return) because the money in the proverbial jar under the bed gradually becomes worth less due to inflation. In a time of deflation, this risk does not apply and the deflationary spiral can hence be worsened by the drying up of credit.
As well as making it less risky to save money, the deflationary spiral also makes it less worthwhile to borrow it. If I borrow $10,000 from you today and pay you back $15,000 after interest over the course of a year at a time of declining prices, I am getting a comparatively worse deal that I would be during a period of inflation because at the end of the year, $15,000 is worth more than it was at the start.
Central banks hence find it harder to convince the other banks to borrow money from them - a measure that might contribute to breaking the deflationary spiral - during a period of deflation. Central banks can offer negative interest on money, which means actually paying someone to borrow it, but this strategy only makes sense when the central bank also exercises some sort of control over how the money is used. Developing countries such as South Korea have used this tactic to stimulate their economies in the early days, but it is much less likely to occur in western countries.
Investment in fixed assets such as property and capital formation dries up during a period of deflation because of the factors that militate against people spending, lending, or borrowing money. When prices are declining generally and demand is low, it is the brave lender who will invest in new capital or a new business when simply keeping his money will result in it becoming more valuable.
Economists split into two schools of thought on how to tackle deflation. Followers of John Maynard Keynes stress the need for the government to deliver a fiscal stimulus, effectively trying to kick-start the economy's engine by increasing demand. With more money sloshing around, prices should hopefully rise. This may require tax cuts or for the government to borrow money to spend on the economic jump leads; this money will need to be paid back later on.
Conversely, monetarists, following in the footsteps of Milton Friedman, argue that the prime tool for battling deflation is a lowering of interest rates and a steady, predictable increase in the money supply. These measures, which Friedman would like to see applied at all times, are designed to allow money to flow as efficiently and cheaply as possible around the economy, hence stimulating demand. Monetarists argue against the direct stimulation of demand by government spending, arguing that it creates inefficiencies that are ultimately harmful to the economy. However, democratic governments, faced with the need to deliver quick palliatives to their electorates, tend to favour the more activist, Keynesian approach.