Defining deflation

Last week we discussed inflation and its consequences for investors. Deflation is the opposite of inflation, and describes a decrease in the general price of goods and services (not to be confused with disinflation, a slow-down in the inflation rate – for example, inflation falling from two per cent to one and a half per cent.

Deflation increases he purchasing power of your money, allowing you buy more goods with the same amount of money over time. A piece of gum that costs $1 this year will cost only 95 cents next year, with five per cent deflation.

Well… lower prices are good, aren’t they? Why wouldn’t the Bank of Canada aim a steady rate of deflation, rather than its current target of two per cent inflation? At fist glance this may seem confusing, but think about more than the cost of goods at the till. When prices fall, so do company profits. This can lead to factory closures and unemployment, which then lead to companies and individuals defaulting on loans. Not very good after all.

As an investor, deflation initially allow for buying stocks at lower prices, but over time, deflation falling profits are not good for the markets.

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