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AS Macro Key Term: Deflation

Geoff Riley

24th May 2011

Deflation is a period when the general price level falls i.e. the cost of a basket of goods and services is becoming less expensive. It is normally associated with falling level of AD leading to a negative output gap where actual GDP < potential GDP. But deflation can also be caused by an increase in a nation's productive potential, which leads to an excess of aggregate supply over demand.

Possible Economic Costs of Deflation

  • Holding back on spending: Consumers may opt to postpone demand if they expect prices to fall further in the future. If they do, they might find prices are 5 or 10% cheaper in 6 months.
  • Debts increase: The real value of debt rises when the general price level is falling and a higher real debt mountain can be a drag on consumer confidence and people's willingness to spend.
  • The real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line with prices – another factor driving spending lower. For example UK policy interest rates were slashed to 0.5% between 2008-09 and have stayed there every since but realistically they cannot go any lower. If RPI and CPI inflation both become negative, the real cost of borrowing increases.
  • Lower profit margins: Company profit margins come under pressure unless costs fall further than prices paid by consumers – this can lead to higher unemployment as firms seek to reduce their costs by shedding labour.
  • Confidence and saving: Falling asset prices such as price deflation in the housing market hit personal sector wealth and confidence – leading to further declines in aggregate demand.

Benign Deflation

Deflation is not necessarily bad! If falling prices are caused by higher productivity, as happened in the late 19th century, then it can go hand in hand with robust growth. On the other hand, if deflation reflects a slump in demand and persistent excess capacity, it can be dangerous, as it was in the 1930s, triggering a downward spiral of demand and prices. If the falling prices are simply the result of improving technology or better managerial practices, that is fine.

Malign Deflation
1/ Malign deflation occurs when prices fall because of a structural lack of demand which creates huge excess capacity in an economic system
2/ If there is a slump in demand, companies go out of business and sack people, and hence demand falls again – the negative multiplier effect starts to have its effect.

John Maynard Keynes on deflation

  • A recession puts downward pressure on prices and wages – but wages tend to be sticky downwards (people resist having their pay cut)
  • So if prices are falling but wages are not, business profits will suffer and this could lead to a huge rise in unemployment.

Irving Fisher on deflation

  • Central banks can only cut nominal interest rates to zero per cent but if prices and wages are falling, real interest rates will rise and the real value of existing business and household debt will increase
  • During a period of recession and deflation, there is a strong incentive for people to use any rise in real incomes to save and pay down some of their debts rather than spend on new goods and services.

Further your awareness

BBC news article (June 2014): is deflation such a bad thing?

Geoff Riley

Geoff Riley FRSA has been teaching Economics for over thirty years. He has over twenty years experience as Head of Economics at leading schools. He writes extensively and is a contributor and presenter on CPD conferences in the UK and overseas.

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