Deflation is generally regarded negatively, as it causes a transfer of wealth from borrowers and holders of illiquid assets, to the benefit of savers and of holders of liquid assets and currency. In this sense it is the opposite of inflation, which is similar to taxing currency holders and lenders and using the proceeds to subsidize borrowers. Thus inflation may encourage short term consumption. In modern economies, deflation is usually caused by a drop in aggregate demand, and is associated with recession and more rarely long term economic depressions.

While an increase in the purchasing power of one's money sounds beneficial, it amplifies the sting of debt. This is because 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. If, as during the Great Depression in the United States, deflation averages 10% per year, even a 0% loan is unattractive as it must be repaid with money worth 10% more each year. Under normal conditions, the Fed and most other central banks implement policy by setting a target for a short-term interest rate - the overnight federal funds rate in the US - and enforcing that target by buying and selling securities in open capital markets. When the short-term interest rate hits zero, the central bank can no longer ease policy by lowering its usual interest-rate target.

In recent times, as loan terms have grown in length and loan financing is common among many types of investments, the costs of deflation to borrowers have grown larger. Deflation discourages investment and spending, because there is no reason to risk on future profits when the expectation of profits may be negative and the expectation of future prices is lower. Consequently deflation generally leads to, or is associated with a collapse in aggregate demand. Without the "hidden risk of inflation", it may become more prudent just to hold on to money, and not to spend or invest it.

Hard money advocates argue that if there were no "rigidities" in an economy, then deflation should be a welcome effect, as the lowering of prices would allow more of the economy's effort to be moved to other areas of activity, thus increasing the total output of the economy.

Deflation has effects on two main levels: on the corporate and on the governmental level.

The most obvious is on the level of companies. By definition, in the event of a deflation, Companies not only cannot raise, but have to actually decrease their prices for their products and services. If they hadn’t decreased their prices, they would go out of business. Although in a deflationary environment, most likely their production costs also decrease, most majority of companies’ profit decrease also, and after a few years they are going to annual losses (there may be companies in sectors with low competition and high profitability ratios, such as utilities, and also companies that have a large portion of profits coming from either foreign operations or from exports). In such scenarios companies cannot plan for and invest in its future growth and development.

When governments want to maintain or increase the real value of their tax income in a deflationary economy, one of three options: increase the tax base, increase tax rates, or a combination of the above two.

Tax base is the number of people and companies that pay taxes. Due to the consumption and corporate environment governments have to be very careful with broadening the tax base, but especially cautious with increasing taxes, as it may cause the economy to sink more deeply into a recession (deflationary economies are also shrinking ones).

Some wages: as companies cannot afford to increase wages, the nominal value of those wages stays the same (however, their real value increases) not only for the period of deflation, but also for some time during the following stagflation and inflationary period.

Deflationary economies have many indirect socio-, political-, financial-, and economical effects:

Rising unemployment: as companies need to cut cost, they need to fire employees, which are not producing (because they don’t have any work to do).

Higher government deficits: as most costs stay the same (for political reasons), and some expenditures increase (e.g.: rising unemployment aid payments cost of jumpstarting the economy).

Recession: no price increase; no economic growth.

More expensive imports: same foreign currency is worth more domestic currency.

More income from exports: same foreign currency income is worth more in domestic currency.

4. Alternative causes and effects

4.1 The Austrian school of economics

The Austrian school defines deflation and inflation solely in relation to the money supply. Deflation is therefore defined to be a contraction of the money supply. Only a decrease in money supply can cause a general fall in prices.

Increased productivity, however, can appear to cause deflation; but it is not general deflation; as the price of produced goods falls, while labor rates remain constant. Austrians show this as a benefit of sound money, which increases or decreases very little in total supply. Prices should simply confer the exchange ratio between any two goods in an economy. Increased productivity generally means less labor for more goods, whereas increased money supply should mean the same amount of labor for the same amount of goods.

For instance if there is a fixed money supply of 400 kg of gold in an economy that produces 200 widgets, then one widget will cost 2 kg of gold. However, next year if output is 400 widgets with the same money supply of 400 kg of gold the price of each widget will drop to 1 kg of gold. In this case the general fall in price was caused by increased productivity.

The opposite of the above scenario has the same effect on prices, but a different cause. If there is a fixed money supply of 400 kg of gold in an economy that produces 200 widgets, then once again each widget will cost 2 kg of gold. However, if next year the money supply is cut in half to 200 kg of gold with the same output of 200 widgets, the price of each widget will now only be 1 kg of gold. When capital profits are dropping rapidly, there is no reason to invest gold, which breaks the savings identity, and thus the automatic tendency of the economy to move back to equilibrium.

Austrians view increased productivity to be a good cause of a general fall in prices, while credit/money supply contraction as being a bad cause of a general fall in prices. Austrians also take the position that there are no negative distortions in the economy due to a general fall in prices in the first scenario. However, in the second scenario where a general fall in prices is caused by deflation, Austrians contend that this confers no benefit to society. For in this scenario wages will simply be cut in half and lower prices will not reflect a general increase in wealth.

Also, Austrians believe that some entity being able to inflate or deflate a money supply is given a privilege, as all prices will not change both simultaneously and proportionally. Rather price changes will occur as a response to what seems to be changes in demand, although this is only in nominal terms. Those who can inflate or deflate the money supply (or those closest to this source) can take advantage of an otherwise unknown change in the money supply by making exchanges that appear sound in nominal terms, but actually confer more profitable exchange rates in real terms, once prices have adjusted to the change.

For example, if a widget costs 5g of gold today and there is 20g of gold in the money supply, if the central bank decreases the money supply to 10g, it can sell its widgets for the formerly agreed upon price. Once the market finds less overall demand, however, prices will halve. While the central banks' money supply deflation was the cause of the price decrease, it received double the money for its widgets that they are now worth in real terms.

4.2 Keynesian economics

Keynesians insist on the distinction between consuming goods and producing goods, and between government based and credit based money supply.

For a given money supply, if wages rise faster than productivity, profits will fall and with them the price of producing goods (deflation), while consuming goods will rise (inflation). This happens in times when labor supply is tight and bargaining power is strong. When wages rise slower than productivity, profits rise as do the prices of assets relative to consuming goods. This can occur when labor supply is great and bargaining power is weak.

Inflation and deflation occur when the economic policies allow wages to increase or decrease at differing rates than productivity. Wages rising faster than productivity lead to inflation. Wages failing to increase at the rate of productivity for protracted periods will ultimately cause deflation.

Indeed, if growth continues despite lagging wages, it is because of debt accumulation, producers lend to wage earning consumers part of their profits, in order to sell their products. For protracted periods, there is a lot of endogenous money creation.

Then, when debt payments exceed the borrower's ability to pay, debt accumulation and endogenous money creation stops, demand and goods' prices fall, manufacturers reduce production, employment falls, and fewer borrowers are thus able to pay their debts, and the cycle exacerbates.

Once preventive action has failed, Keynesians advocate corrective action. In case of debt deflation, Keynesians advocate "pump priming" or government creation of fiat money. As witnessed since 1990 in Japan, and in the 1930s in the USA, this policy is not very effective unless government creates employment via public works projects or military manufacturing.