deflation

Deflation

is a persistent decrease in the average price level of the economy

• Deflation can be categorized as “good” and “bad”   

Why is deflation rare?

1. Wages often do not fall (Keynesian “stickiness”)

2. Oligopolistic firms may fear price wars, which make all firms worse off

“Good” Deflation: reason

• Occurs as a result of improvements in the supply side of the economy, usually increased productivity 

“Good” Deflation: result

• Results in outward shift of LRAS curve, increased output, and lower unemployment, as more workers are needed to produce more output

  • Overall reduction in average price level 

“Bad” Deflation: reason

• Occurs as a result of reduced AD

“Bad” Deflation: result

• Results in reduced real output average price levels 

• Reduced output = higher unemployment

  • Reduced spending and therefore reduced economic growth

Costs of “Bad” Deflation

• Higher unemployment 

• Redistribution effects

• Increase in the real value of debt

• Uncertainty

• Less investment

• Reduced spending 

• Risk of bankruptcy

• Policy ineffectiveness

Costs of “Bad” Deflation

• Policy ineffectiveness

• Monetary policy is ineffective because people may not want to take on new debt 

Costs of “Bad” Deflation

• Risk of bankruptcy

• If the real value of debt increases, and incomes and spending are falling, then many consumers and firms will be unable to pay their debts and go bankrupt

Costs of “Bad” Deflation

• Reduced spending 

• If consumers expect prices to fall, they may hold off on major purchases (deferred consumption)

• A reduction in spending results in falling AD and higher unemployment, which perpetuates into a deflationary spiral (see diagram) 

Costs of “Bad” Deflation

• Less investment

• Reduced price levels mean lower profits for businesses, which leads to less investment, reduced AD and stagnating economic growth

Costs of “Bad” Deflation

• Uncertainty

• This can translate into reduced consumer confidence, which negatively affects AD; similarly, firms are unable to forecast costs and revenues

Costs of “Bad” Deflation

• Increase in the real value of debt

• Deflation means an increase in purchasing power, and therefore the real value of debt increases 

Costs of “Bad” Deflation

• Redistribution effects

• Individuals on fixed incomes (pensioners), cash holders, and savers and lenders (creditors) all see and increase in the real value of their income or assets, while borrowers (debtors) and payers of fixed incomes lose 

Costs of “Bad” Deflation

• Higher unemployment 

• Reduced AD means businesses will need to sack workers, which further reduces AD