Explaining Price Deflation - Causes, Effects and… | tutor2u Economics
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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 http://www.bbc.co.uk/news/business-31050192

(BBC Robert Peston, Jan 2015): Could 'good' low inflation become 'bad' deflation? http://www.bbc.co.uk/news/business-30795424

Deflation danger for the Euro? http://www.bbc.co.uk/programmes/p02g37r1

(BBC Robert Peston, Oct 2014) Why Germant won't fight price deflation http://www.bbc.co.uk/news/29649073

(Guardian, Jan 2015) Analysts fear financial crisis as Chinese deflation looms: http://www.theguardian.com/business/2015/jan/09/ch...

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

MCQ policies to avoid deflation - revision video

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