Deflation happens when prices of goods and services are falling in an economy. It is the opposite of inflation.
Causes of deflation: In mainstream economics, deflation may be caused by a combination of the supply and demand for goods and the supply and demand for money, specifically the supply of money going down and the supply of goods going up.
From a monetarist perspective deflation is caused primarily by a reduction in the velocity of money and/or the amount of money supply per person.
In modern credit-based economies, a deflationary spiral may be caused by the (central bank) initiating higher interest rates (i.e., to 'control' inflation), thereby possibly popping an asset bubble or the collapse of a command economy which has been run at a higher level of production than it could actually support.
Effects of deflation: Deflation increases sales and economic activity by making essentials (food, housing, fuel etc.) which cannot be delayed, more affordable to struggling consumers, thereby reducing severity and duration of recession.
In more recent economic thinking, deflation is related to risk: where the risk-adjusted return of assets drops to negative, investors and buyers will hoard currency rather than invest it, even in the most solid of securities. This can produce the theoretical condition, much debated as to its practical possibility, of a liquidity trap.
Deflation is, however, the natural condition of hard currency economies when the rate of increase in the supply of money is not maintained at a rate commensurate to positive population (and general economic) growth. When this happens, the available amount of hard currency per person falls, in effect making money more scarce; and consequently, the purchasing power of each unit of currency increases. The late 19th century provides an example of sustained deflation combined with economic development under these conditions.
Counteracting deflation: Until the 1930s, it was commonly believed by economists that deflation would cure itself. As prices decreased, demand would naturally increase and the economic system would correct itself without outside intervention.
This view was challenged in the 1930s during the Great Depression. Keynesian economists argued that the economic system was not self-correcting with respect to deflation and that governments and central banks had to take active measures to boost demand through tax cuts or increases in government spending. Reserve requirements from the central bank were high and the central bank could then have effectively increased money supply by simply reducing the reserve requirements and through "open" market operations (e.g., buying treasury bonds for cash) to offset the reduction of money supply in the private sectors due to the collapse of credit (credit is a form of money).
With the rise of monetarist ideas, the focus in fighting deflation was put on expanding demand by lowering interest rates (i.e., reducing the "cost" of money). This view has received a setback in light of the failure of accommodative policies in both Japan and the US to spur demand after stock market shocks in the early 1990s and in 2000 - 2002, respectively. Economists now worry about the (inflationary) impact of monetary policies on asset prices. Sustained low real rates can be the direct cause of higher asset prices and excessive debt accumulation. Therefore lowering rates may prove only a temporary palliative, leading to the aggravation of an eventual future debt deflation crisis.