For many baby boomers, "deflation" and "the U.S. economy" conjures up images of the Great Depression, through which their parents and grandparents lived. Marked by one of the strongest bouts of deflation, unemployment, and economic misery in this country's experience, that decade haunts because so many of us have been led to believe it couldn't happen again, and because so many Americans alive today have never experienced anything but virtually uninterrupted prosperity.

Yet, while deflation is certainly not good for the U.S. economy, it may not bring with it the kind of misery that the doomsayers suggest. A review of these fundamental concepts of changes in prices may help you see and adapt to current developments a little better.

Moderate Inflation: Sign of a Healthy Economy

Simply defined, economic inflation means rising prices for goods and services. It's measured in a number of ways, but the most well known is the Consumer Price Index, or CPI. Compiled by the U.S. Department of Labor's Bureau of Labor Statistics, it measures the change in prices for an average market basket of consumer goods and services purchased by nearly 90% of the U.S. population.

Between 1926 and 2008, the U.S. experienced a healthy and moderate average rate of inflation of 3% a year. Moderate and stable inflation is good, for two reasons. First, moderate inflation is a sign of economic growth - increasing amounts of wealth - which facilitates an expansion of production and higher standards of living. Second, stable rates of inflation enable businesses and consumers to make reliable plans for spending and investment.

One way to see inflation as a positive factor is from the perspective of a homeowner. Many people who buy a new home stretch their budgets to obtain the nicest home they can. But as they earn more money, each year their debt payments eat up a smaller and smaller percentage of their income (if their mortgage features a fixed rate of interest). This gives them more money to spend on other things, which stimulates more economic growth.

The Problem with High Inflation Rates

Much above the "Goldilocks" rate of 2.5% to 3.5% a year, inflation can cause an economy to go off track. For one thing, higher inflation rates are often accompanied by instability in the rate of inflation, which disrupts investment and spending both by businesses and consumers. High rates of inflation put a strain on businesses to raise prices to balance their rising expenditures on labor and materials - without causing sales to decline.

As inflation rates increase, bond investors bid interest rates higher, which ultimately causes some borrowers to be turned down for loans. The danger is that, squeezed by higher costs of goods and debt, consumers and businesses cut back on spending - and that can lead to lower production, layoffs, and recession.

Disinflation: Slowing Inflation

Disinflation is, quite simply, the reduction in the rate of inflation. When high inflation undermines economic growth, disinflation moves the needle of price changes lower, eventually to a level where economic growth resumes. In that sense, disinflation is the remedy for inflation that is too high.

Many people confuse disinflation, which is a trend toward lower rates of inflation, with another condition: deflation.

Deflation: Falling Prices That Hurt Everybody

Deflation isn't a cure for inflation. It's the opposite of inflation - falling prices. While everybody likes to see prices come down for some things, it's only good for the economy when it's the result of higher productivity. As manufacturers of computers and color TVs, for example, became more productive, prices for those goods fell.

But deflation is said to occur when the prices of almost everything decline. The cause: people spending less. When businesses make less money, they're often forced to cut wages or lay off workers, which leads to a downward spiral of less spending, more layoffs, higher unemployment, and economic stagnation - or worse.

Returning to the example of the homeowner, it's easy to see the nastiness of deflation. Imagine a homeowner in an environment of deflation. The homeowner still has his job, but his income is reduced. This makes his debt payments relatively more expensive and reduces the amount of money he has to spend on other things. If the deflationary spiral continues over an extended period of time, the homeowner might be unable to continue making his mortgage payments and lose his home.

Deflation reflects a decline in the sum total of money chasing goods. Once an economy is caught in a deflationary spiral, it's very difficult to overcome. Central banks try to stimulate borrowing and spending by reducing interest rates, but when rates reach 0%, there's no more room left for monetary policy to stimulate growth.

Deflation Doesn't Necessarily Mean Depression

If these conditions sound familiar, they should. To date, we haven't descended into deflation -- yet -- but the U.S. Consumer Price Index recorded its lowest rate in 54 years in 2008. At 0.1%, inflation was tamer than at any time since 1955 (Source: National Bureau of Economic Research, 2009). The U.S. economy last experienced deflation in the 1930s, when six out of 10 years were characterized by deflation.

As we learned during Japan's deflationary "lost decade" of the 1990s, deflation isn't always accompanied by an economic depression. During that period, Japan's economy grew in every year except two, but its average growth rate was a meager 1.5% a year, compared to 9% a year from 1956 to 1973, and 4% a year in the 1980s.

Whether the U.S. is teetering on the brink of deflation, or has merely come to the end of a period of disinflation, matters less than what conditions are doing to the emotions of investors. Stressful times often lead investors to make the wrong decisions. Knowledge and perspective are keys to making wise decisions.