What Causes Deflation?

Let us assume that in a village there are only ten goods and ten Rs 10 notes are available to purchase them with. We can safely assume that each item will end up costing Rs 10 each.

Case 1. If the quantity of money increases to Rs 200 (without increasing the quantity of goods) the price will increase to Rs 20 per good - that is inflation.

However, the quantity of money decreases to Rs 50 then price of each good will fall to Rs 5, this will be termed as deflation. This is what the first part of the above definition is referring to.

Case 2. Now even money supply can also be reduced if someone in the village hoards half of it and refuses to spend it on anything no matter what. This is the second part of the definition (reduction in spending).

Case 3. Well let us change the assumptions a bit. While there are only Rs 100, and instead of having ten items ten more are built by the villagers. So now though there are twenty items in the village but the money is still Rs 100 (as it was initially) so once again each item is worth Rs 5 (Rs 100 divided by 20 items).

Everyone has assumed that deflation is bad because the last time there was a major deflation was during the time of "Great Depression". This is why deflation and depression are synonymous in many peoples minds.