Deflation

Key Terms

Deflation: A general and sustained fall in the price level

Theory

Types of Deflation

Benign Deflation

General prices can often fall due to higher productivity. This can be stimulated by a number of factors e.g. beter manegerial practise of technological innovation. The initial deflation is accompanied by strong growth and is therefore not a problem.

Malign Deflation

Malign deflation arises due to a structural lack of demand. This is caused by the unwillingness of consumers and businesses to spend thus causing a negative multiplier effect which further stiumlates a deflationary cycle.

Advantages of Deflation

1) Signals increase in productivity

If firms are more productive then they may be able to reduce the cost of their product. Deflation may therefore reflect a general increase in the efficiency and productivity of firms.

2) Increase in living standards

Assuming that wages are 'sticky' downwards, then when prices fall, wages can buy more goods and services. This means therefore that household income can buy more goods thus reflecting an increase in living standards.

Disadvantages of Deflation

1) Collapse in demand

Deflation makes money appear stronger. As prices fall consumers put off spending and wait until the last moment to get the best possible price.

2) Monetary Policy becomes ineffective

In the event of deflation, central banks lower the inflation rate to stimulate borrowing and spending. However even if the nominal interest rate is zero, the real interest rate will be positive if there is delation. This is because as deflation persists, £1000 will buy more at the end of the year than at the start of the year.

Deflation therefore renders monetary policy useless as it can only influence nominal interest rates.

3) Raises the real value of a debt burden

If someone takes out a mortgage or a loan the amount they have to pay back each month remains fixed. When deflation exists in the economy, prices are falling, this may cause wages to fall. Therefore the amount that is paid back each month increases even if the value of the repayment remains the same in nominal terms.

The threat of not being able to afford repayment discourages consumers and businesses from borrowing thus hindering growth