What’s the Definition of Deflation?

Deflation is a contraction in the total supply of money and credit in an economy.

Inflation is an expansion in the total supply of money and credit in an economy.

It is vitally important to understand the difference between monetary deflation / inflation and declining / increasing prices.

We use the monetary definition which describes what is happening to money and credit in an economy. This is the true definition of deflation and inflation. Its origins date to the 16th century in  the writings of the Prussian polymath Nicolaus Copernicus, as well as followers of the School of Salamanca such as Martín de Azpilcueta, who noted an increase in the overall price of goods as traders brought gold and silver back from the Americas to Europe. That observation, via the writings of among others, John Locke, David Hume and Ludwig von Mises, has led to the Quantity Theory of Money, which hypothesizes a link between the quantity of money/credit and the level of goods prices in an economy. Although there are still arguments over the exact nature of the link between money/credit and prices, the important point to note is that the terms deflation and inflation relate to the money/credit side and not to the price side.

Money and credit are not prices; they are the means of exchange for goods and services that do have a price. Unfortunately, society has conditioned us to think of deflation as falling prices and inflation as rising prices. This is wrong. Although many economists and the financial media define deflation as falling prices and inflation as rising prices, this is misleading because what they are actually describing are potential effects of deflation and inflation, not what they are.

Prices for goods, services and even credit go up and down, and there are various reasons why this is so. Production efficiency, for example, can lead to falling prices, and a shortage in wartime can lead to rising prices. Some sectors of the economy have rising prices whilst others, perhaps due to technological advances, have falling prices. (Ultimately, credit expansion and contraction is a result of a positive or negative mood trend.) Prices are not actually deflating or inflating, they are simply moving up and down. Price declines and price increases are potential effects of money and credit deflation and inflation, the true definition of deflation and inflation.

So under the true definition of deflation and inflation it is the total supply of money and credit in an economy that is important. What are money and credit?

Money is a socially accepted medium of exchange, value storage and final payment. A specified amount of that medium also serves as a unit of account.

Credit is the right to access money. Credit can be held by the owner of the money (a checking account at the bank) or it can be transferred (lent) in exchange for a fee called interest via a repayment contract such as a bond. This is called debt. In today’s economy, most credit is lent so the terms credit and debt are used interchangeably. Credit can be self-liquidating where the accessed money is used to enhance production in an economy, or it can be non-self-liquidating where the money accessed is used for consumption purposes.