Study Notes

Explaining Price Deflation - Causes, Effects and Policies

  • Levels: AS, A Level
  • Exam boards: AQA, Edexcel, OCR, IB

What is price deflation?

Price deflation happens when the rate of inflation becomes negative. I.e. the general price level is falling and the purchasing power of say £1,000 in cash is increasing

  • Some countries have experienced periods of deflation in recent years; perhaps the most well-known example was Japan during the late 1990s and in the current decade. In Japan, the root cause of deflation was slow growth and a high level of spare capacity that was driving prices lower.
  • Greece and a number of Euro Area countries are now experiencing price deflation as are countries such as Switzerland and Denmark

What are the main causes of deflation?

Causes of deflation - revision video

Why might deflation be damaging for an economy?

  1. Holding back on spending: Consumers may postpone demand if they expect prices to fall in the future
  2. Debts increase: The real value of debt rises with deflation and higher real debts can be a big drag on consumer confidence
  3. The real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line with prices.
  4. Lower profit margins: Lower prices can mean reduced revenues & profits for businesses - this can then lead to higher unemployment as firms seek to reduce costs by shedding labour.
  5. Confidence and saving: Falling asset prices such as price deflation in the housing market hits personal sector wealth and confidence
  6. Income distribution: Deflation leads to a redistribution of income from debtors to creditors – but debtors may then default on loans
  7. Deflation can make exporters more competitive eventually – but this often comes at a cost i.e. higher unemployment in short term
Consequences of deflation - revision video

What economic policies might be used to avoid a period of price deflation?

The main approach to avoiding deflation is to use macro-stimulus policies either by loosening monetary policy and/or fiscal policy

Low interest rates and quantitative easing

  • In some countries, policy interest rates have become negative e.g. Switzerland and Japan
  • Cheaper loans for businesses and households
  • Expanding the supply of credit in banking system
  • QE used by many central banks including BoE and European Bank

Fiscal stimulus measures

  • Higher government spending (e.g. capital projects)
  • A rise in government borrowing to inject demand into the circular flow
  • Lower direct taxes to increase disposable income and spending

Other measures to stimulate aggregate demand

  • Attempts to lower (devalue) the value of the exchange rate (perhaps via central bank intervention to sell their currency in the market)
  • Higher taxes on savings to encourage consumption
Policies to avoid deflation - revision video

Relevant articles on the issue of deflation

(BBC, Jan 2015): Denmark, Deutschland and deflation: strange times for EU

(BBC Robert Peston, Jan 2015): Could 'good' low inflation become 'bad' deflation?

Deflation danger for the Euro?

(BBC Robert Peston, Oct 2014) Why Germant won't fight price deflation

(Guardian, Jan 2015) Analysts fear financial crisis as Chinese deflation looms:

Test your Knowledge MCQ on Policies to Avoid Deflation - revision video

MCQ policies to avoid deflation - revision video

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