Whereas inflation signals an increase in the price of goods and the cost of living, deflation refers to the opposite, when the price of basic goods decreases. This may sound like a positive outcome, as it will ensure that the things you need to survive can be purchased for less money. But it is usually caused by a decrease in the supply of money or a decrease in available credit, which typically has a very negative affect on the economy.
Deflation can also be caused by a drop in government spending, because they are one of the biggest spenders and without the millions that they pump into the economy every year, that economy suffers.
One of the side effects of deflation is an increase in the unemployment rate. There are many reasons for this, the main one being a lack of demand, which reduces the profits made by companies and means they are forced to tighten their belts.
Central banks will always do what they can to stop deflation from becoming severe. This is something that can be predicted, something that can be accounted for, with measures put in place to stop it from getting out of control. But if those measures fail, or if the problem is too big for those banks to control, then the economy could slip into an economic depression.
Economic depression refers to a period of sustained economic downturn, typically one that lasts for at least two years. Perhaps the most famous example of this was the Great Depression, a period between the two World Wars in which the stock markets crashed, the unemployment rate soared and the world was in financial distress.
Similar to deflation is the term “Stagflation”. This refers to a period of high unemployment and economic stagnation (with no inflation). Most famously, this occurred in a number of first-world countries during the 1970s, as poor economic growth was made worse by an increase in the price of oil.