The consequences of deflation
Deflation is a persistent, continuous decrease in the price level or a situation in which output and employment are falling as a result of a fall in AD.
Syllabus: Discuss the possible consequences of deflation, including high levels of cyclical unemployment and bankruptcies.
The term deflation is often used in a broad sense to describe a process in which there is a fall in aggregate demand leading to lower levels of output, employment, investment and possibly profits and prices.
Costs of deflation
- As with inflation Uncertainty is a major force against investment and while prices are falling businesses will be reluctant to put funding into investment when the real value of returns cannot be accurately estimated.
- The problem of deflationary expectations - deflation may cause people to postpone their spending in the expectation of even lower prices in the future. When this happens, aggregate demand falls, businesses are unable to sell their goods, make profits or meet their debt repayment obligations and, as a consequence, may be forced to cut output and employment of workers. A downward spiral becomes established in which aggregate demand falls even further leading to even lower prices. As Japan has discovered in the mid-1990s, once a downward deflationary spiral sets in, it may be exceedingly difficult to reverse.
- Deflation increases the value of real debt - with some inflation in the system, borrowers experience a fall in the real value of their debt over time. However, with falling prices borrowers will experience an increase in the real value of their debt and in such a climate, companies and individuals with debt may struggle. This in itself may exert a further twist to the downward deflationary spiral.
Past Paper Essay Question
May 2012 TZ1
2. (a) Explain why governments may view deflation as a threat. [10 marks]
(b) Evaluate the view that a low and stable rate of inflation is beneficial for an economy. [15 marks]