Inflation and deflation- Deflation

Problems, causes and policies

What is deflation?

A sustained decrease in the average price level.

What are the two main causes of deflation?

• Demand side 

• Supply side

What is demand side deflation caused by?

A fall in AD, often referred to as ‘bad’ deflation.

Why is demand side deflation known as ‘bad’ deflation?

Due to the economic conditions that arise from falling AD- recession, rising unemployment and falling living standards.

Demand side deflation diagram

Why is supply side deflation known as ‘good’ deflation?

Due to the cause: rising LRAS implies the possibility of  technology and productivity improvements which go hand in hand with higher AD etc. 

Why does ‘good’ inflation not usually last long?

It is usually accompanied with higher AD.

How else can deflation occur in the short run?

By a rightward shift of the SRAS curve, due to falling cost productions. 

What are the problems of deflation?

• Discourages consumer spending

• Increased real interest rates

• Real wage unemployment 

What are deflationary expectations?

The belief by economic agents that prices in general are likely to fall in the following time period. 

What are the benefits of deflation?

• Deflation from increased efficiency and lower costs of production 

• Improved international competitiveness 

What are some examples of reflationary demand side policies?

• Higher government spending

• Lower taxes

• Reduction in interest rates 

• Quantitative easing 

• Helicopter money drop 

What is a liquidity trap?

Occurs when monetary policy becomes ineffective because, despite zero/low interest rates people want to hold on to their cash rather than spend it.