One major mistake that many people make in economics, including many so-called economists, is that they confuse cause and effect. Deflation doesn’t cause a depression/recession any more than a wet street causes rain. Whether we are talking price deflation or monetary deflation, it isn’t really a cause of a depression. You could say that monetary deflation can trigger a depression, but the depression was already built into the cake if that is the case. The Austrian Business Cycle Theory teaches us that if there is monetary inflation, it will cause bad investments to take place, and there inevitably has to be a bust. If there is monetary deflation or even a decrease in monetary inflation, then the boom may come to an end. If there is never a slowdown in the rate of monetary inflation, then you will eventually get hyperinflation.

Going back to deflation, during the Great Depression, there was monetary deflation at the beginning. This was because there was no FDIC to bail out banks and their depositors. There were runs on banks and the fractional reserve lending process reversed itself. With the FDIC today, you won’t have a similar situation.

As far as price deflation, it is possible to have a slight decrease in prices, even if the Fed is inflating the money supply. First, you can have a situation as we have right now where the banks increase their excess reserves voluntarily. But another scenario still is that during an economic downturn, people have a greater demand for money. They are more likely to save money and spend less. Money will change hands less quickly. This can have the same effect as a decrease in the money supply. With less people spending, there will be less people to bid up prices. It is possible for prices to fall even if there is monetary inflation.

But let’s remember that falling prices aren’t a bad thing. In a recession, where the economy is trying to flush out the bad investments, it helps people that they don’t have to pay as much for food, gas, and other items. Price deflation is a cure. It should not be seen as part of the disease.