Deflation What you must be able to do: evaluate the causes of deflation evaluate the consequences of deflation.

Deflation A situation in which the average level of prices is falling – negative inflation https://shaundacosta.wordpress.com/2013/04/08/combating-deflation-the-japanese-experience/

Countries with the lowest inflation rate in 2015 Source: IMF Deflation is a persistent fall in a country’s general price level. A number of countries were experiencing negative inflation rates in May 2015 among them a growing cluster of countries inside the European Union.

The Causes of Price Deflation Deflation is a persistent fall in the general price level of goods and services. The rate of inflation becomes negative. Demand-side causes of deflation Deep fall in AD causing a persistent recession / depression Large negative output gap – i.e. high level of spare capacity Supply-side causes of deflation Improved productivity Technological advances Significant fall in wage rates High exchange rate causing import prices to fall GPL AS1 AS2 GPL1 GPL2 AD1 AD2 Y2 Y1 Real GDP

Decrease in AD Use an appropriate diagram to illustrate this. Possible causes Reduced consumption and investment Reduced government spending Reduced exports What factors could cause the components of AD to decrease?

Deflation due to reduced AD- evaluation Deflation caused by reduced AD is considered “bad”. Reduced real GDP – downward multiplier effects Reduced employment, Increases government spending on benefits – budget deficit. Must be financed e.g. increased borrowing and reduced spending Consumers delay spending – expect further price falls, or pessimistic about the future Firms reduce Investment

Evaluating the causes of deflation Size/degree of decrease in AD. Size of any downward multiplier effects LRAS elasticity/slope – if vertical AD decreases will have no impact on output, but a large impact on the price level – competitiveness will increase in the long run…. Other factors may change reducing the impact of decreased AD. Another AD component may change, or AS may increase- the impact will depend on whether AS is Keynesian or Vertical(Classical) There may be a time lag – consider short run and long run impacts Duration of deflationary period – short or long period

Increased AS Use an appropriate diagram to illustrate this. Possible causes Improved productivity Technological advances Significant fall in wage rates High exchange rate causing import prices to fall What factors could cause the AS to increase?

Evaluating the causes of deflation Size of increase in AS Slope of AD curve – If steep there will be a larger impact on the price level, but in the long run the increased competitiveness might raise demand for exports and reduce demand for imports – AD shifts right. Time period – outward shifts of AS can take a long time (see supply side policies) An increase in AS is considered “good” – improved competitiveness for an open trading economy. Consumers benefit from lower priced, better quality goods….

Evaluating the consequences of deflation NB – these will depend on the cause If due to decreased AD – economically undesirable… If due to increased AS– economically desirable…

Evaluating the Consequences of Price Deflation Holding back on spending: Consumers may postpone demand if they expect prices to fall in the future Debts increase: The real value of debt rises with deflation and higher real debts can be a big drag on consumer confidence The real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line with prices. 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. Confidence and saving: Falling asset prices such as price deflation in the housing market hits personal sector wealth and confidence Income distribution: Deflation leads to a redistribution of income from debtors to creditors – but debtors may default on loans Deflation can make exporters more competitive eventually – but this often comes at a cost i.e. higher unemployment in short term

Evaluating the Consequences of Price Deflation Real interest rates rise Real level of debt rises Pressure for lower wages Declining business profits Rise in cyclical unemployment Improved price competitiveness

Consequences of deflation - evaluation Size/degree of the consequence How long is the deflationary period Frequency of the consequence Redistribution effects – are these significant? Other factors may change that reduce/increase the impact Policy changes may be swift to deal with adverse impacts How open an economy is to trade – deflation caused by increased AD raises international competitiveness Consider the significance of the effect!! Make a judgement

Questions Using a diagram analyse the possible impact of a decrease in AD on the economy. (6) Using a diagram analyse the possible impact of an increase in AS on the economy. (6) Explain 2 factors that could result in a decrease in (a) consumption and (b) investment (6)