Deflation is a situation in which the trend of the purchasing power of a currency is increasing. Thus, a person with a fixed amount of money is able to buy more with the money than had been the case in a prior period. This condition occurs when the supply of money circulating in the economy has declined. Deflation occurs when the holders of currency prefer to save it, so that the currency is essentially withdrawn from the money supply. It can also happen when there is a general increase in productivity, so that the supply of goods and services increases in proportion to the money supply.

In a deflationary environment, a firm with large cash holdings is more attractive than a business with large debt holdings, since it is relatively more difficult to pay off the debt.