Reading through the comments in the deflation threads it appears there is some confusion around the meaning of the term and the implications on deflation (and by implication inflation).
One way to think about the issue is in terms of the functions of money. Money has three functions:
- Medium of exchange – here money breaks down the double coincidence of wants.
- Store of value – money can be stored and used at a future date.
- Unit of account – money provides a measure of value.
As a store of value money must have a predictable future value – preferably the same value as it has now. Ideally money will have a stable value over time. So that $100 today buys a bundle of goods and services worth $100 and can still do so in one year, or two years and so on.
But we know the purchasing power of money isn’t stable – in a fiat money regime it is very likely that $100 will not be able to buy the same bundle of goods and services in one years time as it does now. Invariably it will be able to buy less. Prices will have risen. That process is often referred to as inflation. But that is only half the story – one of two things could have happened.
- The goods and services in the bundle could have become more valuable due to shortages or a new use for those goods. This is a change in relative prices.
- The value of the money itself could have declined – the purchasing power of the money declined. Strictly speaking this is inflation.
Similarly $100 could buy more than $100 can today. Prices have fallen. This process is often referred to as deflation. But that is only half the story – one of two things could have happened.
- The goods and services in the bundle could have become less valuable due to surpluses, new sources of supply, or consumers not valuing those goods as highly as entrepreneurs, or improvements in technology or productivity. This is a change in relative prices.
- The value of the money itself could have increased – the purchasing power of the money increased. Strictly speaking this is deflation.
In each case (2) is a problem but (1) isn’t. In each (2) case what we observe – a change in prices – is being driven by money not maintaining itself as a store of value. This can lead to consumer and entrepreneurial error as decision makers respond to faulty price signals. Economic decision making becomes distorted.
So failure to act as a store of value results in money not being a good unit of account leading to exchanges that would not otherwise occur.
Now I’m happy to believe that fiat money will result in inflation, and I’m happy to believe that economies can and will shrink or grow, and I’m happy to believe that goods and services can become more or less valuable as relative prices change. I’m not convinced that fiat money can result in deflation – paper money becoming more valuable?
Now the story can get a lot more complicated than that – Mises, for example, argues that inflation and deflation are political terms and not economic terms and that we shouldn’t expect money to neutral (i.e. work as a store of value).