Consequences of Deflation
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Last updated 16 Jan 2023
Why are falling prices widely regarded as damaging for an economy? This revision video looks at some of the consequences of a period of price deflation.
Deflation is a sustained decrease in the overall price level of goods and services in an economy. It can be economically damaging for a number of reasons:
- Decrease in consumer spending: When prices are falling, consumers may delay purchases in the hope of getting a better deal in the future. This can lead to a decrease in overall consumer spending and economic activity.
- Increase in real debt burden: Deflation increases the real value of debt, making it more difficult for borrowers to repay their loans. This can lead to defaults, foreclosures, and bank failures.
- Difficulty for firms to raise prices: Deflation can make it difficult for firms to increase prices, which can lead to decreased profits and a decrease in investment.
- Difficulty in monetary policy: Central banks typically use monetary policy tools such as interest rate adjustments to stabilize the economy. However, deflation can make it difficult for central banks to stimulate the economy with monetary policy because interest rates cannot normally fall below zero. This is called the zero bound.
Real-world examples of deflation include:
- The Great Depression of the 1930s, which was characterized by a severe deflationary spiral.
- Japan's "Lost Decade" of the 1990s, where Japan struggled with deflation and economic stagnation for an extended period of time.
- The Eurozone crisis of 2011-2012 where several countries like Greece, Ireland, Portugal, and Spain faced deflation as a result of the debt crisis which affected their economies.
In general, deflation is considered a harmful phenomenon and Central Banks and Governments take measures to avoid it.