Suppose the price level reflects the number of dollars needed to buy a basket of goods containing one cup of coffee, one donut, and one newspaper. In year one, the basket costs $10.00. In year two, the price of the same basket is $9.00. From year one to year two, there is at an annual rate of . In year one, $72.00 will buy baskets, and in year two, $72.00 will buy baskets. This example illustrates that, as the price level falls, the value of money .

From year one to year two, there is DEFLATION at an annual rate of 10%. In year one, $72.00 will buy 7 baskets, and in year two, $72.00 will buy 8 baskets. This example illustrates that, as the price level falls, the value of money INCREASES.

Explanation:

year        basket price

1                   $10

2                   $9

% change = (9 - 10) / 10 = -1 / 10 = -0.1 or -10% or 10% deflation rate

Deflation refers to a reduction in the general price level. As deflation increases, the purchasing power of the currency increases. It is the opposite to inflation.

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