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A fall in the rate of inflation (known as disinflation) means that prices are still rising, only at a
slower rate. Be clear about the meaning of deflation -an actual fall in the general price level.
Deflation is defined as a persistent fall in the general price level of goods and services in the
economy over a period of time- in other words, the inflation rate is negative.
The purchasing power of money increases during the period of deflation, that means that more
goods can be purchased with the same amount of money one has. Long term deflation turns into a
recession and hence, is very dangerous. It can lead to a financial crisis with increased poverty, job
losses, bankruptcies, defaults, and outflow of investment from the economy.

Causes of Deflation
Aggregate supply = Deflation can be caused by higher levels of aggregate supply, increasing the
productive capacity of the economy .This drives down the general price level of goods and
services while increasing national income. Such deflation is called benign deflation (non-
threatening deflation). For example, supply-side policies such as investment in education and
infrastructure ,higher productivity, improved Inflation managerial practices, technological advances
and government subsidies for major industries all help to raise national income in the long run. In
Figure , this is shown diagrammatically by a rightward shift of the aggregate supply curve from AS
to AS1 reducing the general price level from P to P1.

If deflation is caused by rising productivity, improved technology and lower costs, the deflation
may not be harmful but beneficial.

Aggregate demand = Deflation can also be caused by lower levels of aggregate demand in the
economy, driving down the general price level of goods and services due to excess capacity in the
economy. This causes what is known as malign deflation (deflation that is harmful to the
economy). For example, during an economic household consumption of goods and services falls
due to lower GDP per capita and higher levels of unemployment. In Figure , this is shown by a
leftward shift of the aggregate demand curve from AD1 to A Di, reducing national income from Yi
to Y2 , and forcing down the general price level from P1 to P2 .This cause of deflation is a concern
as it is associated with a decline in national income and standards of living.
The consequences of deflation

The consequences of deflation depend on whether we are considering benign deflation or

malign deflation. The consequences of benign deflation are positive as the economy is able
to produce more, thus boosting national income and employment, without an increase in the
general price level. This therefore boosts the international competitiveness of the country.
However, malign deflation is generally harmful to the economy. The consequences of malign
deflation include the following:

Problems of Deflation

1. Discourages consumer spending. When there are falling prices, this often
encourages people to delay purchases because they will be cheaper in the future. In
particular, it can discourage consumers from buying luxury goods / non-essential
items, e.g. flatscreen TV – because you could save money by waiting for it to be
cheaper. Therefore, periods of deflation often lead to lower consumer spending and
lower economic growth; (this, in turn, creates more deflationary pressure in the
economy).
2. Increase real value of debt. Deflation increases the real value of money and the
real value of debt. Deflation makes it more difficult for debtors to pay off their debts.
 Therefore, consumers and firms have to spend a bigger percentage of disposable
income on meeting debt repayments. (in a period of deflation, firms will also be
getting lower revenue, and consumers will likely to get lower wages). Therefore, this
leaves less money for spending and investment.
The real cost of debts (borrowing) increases when there is deflation. This is because
real interest rates rise when the price level falls. For example, if interest rates
average 1.0 per cent but the inflation rare is - 1.5 per cent, then the real interest rate
is 2.5 percent (imagine the situation of falling house prices while having to pay
interest on mortgages taken out when prices were higher). Thus, with deflation and
the subsequent rising real value of debts, both consumer and business confidence
levels fall, further adding to the economic problems in the country.

3. Increased real interest rates. Interest rates can’t fall below zero. If there is deflation
of 2%, this means we have a real interest rate of + 2%. In other words, saving money
gives a reasonable return. Therefore, deflation can contribute to an unwanted
tightening of monetary policy. This is another factor that can lead to lower growth
and higher unemployment.

4. Real wage unemployment. Labour markets often exhibit ‘sticky wages’. In

particular, workers resist nominal wage cuts (no one likes to see their wages actually
cut, especially when you are used to annual pay increases. Therefore, in periods of
deflation, real wages rise. This could cause real-wage unemployment.

5. Bankruptcies – During periods of deflation, consumers spend less so firms tend to

have lower sales revenues and profits. This makes it more difficult for firms to repay
their costs and liabilities (money owed to others, such as outstanding loans and
mortgages). Thus, deflation can cause a large number of bankruptcies in the
economy.

6. Wealth effect – As the profits of firms fall, so do their valuations, i.e. share prices fall
during times of deflation. This means that dividends and the capital returns on
holding shares fall, thus reducing the wealth of shareholders.

7. Government debt – With more bankruptcies, unemployment and lower levels of

economic activity, tax revenues fall whilst the amount of government spending rises
(due to the economic decline associated with malign inflation). This creates a budget
deficit for the government, meaning that it needs to borrow money even though the
real cost of borrowing rises with deflation.

8. Consumer confidence – Deflation usually causes a fall in consumer confidence

levels as they fear things will get worse for the economy. Thus, they may postpone
their spending, especially on consumer durable goods such as cars and furniture, as
they expect prices to fall even further in the future or they will wait until the economy
improves. This clearly does not help the economy to recover, thereby causing a
downwards deflationary spiral.
 Deflation spiral

Deflation spiral

Deflation can become a self-reinforcing loop. Falling prices create circumstances for prices to
continue falling.
 • With falling prices – firms want to cut wages – lower wages lead to less spending
(AD) and lower costs.
• Falling prices lead to a decline in confidence, and therefore lower spending and
lower investment.
• Deflation leads to expectations of falling prices – people won’t spend unless prices
fall and they can delay spending until they do.

• Deflation creates expectations of further price falls, and therefore consumers reduce their
spending because they expect goods to become spending in the future. This fall in
spending creates further deflationary pressure in the economy.
• Deflation increases the real value of debt. This makes it harder to meet repayments and
companies are more at risk of going bankrupt. Because bankruptcies increase, banks
become reluctant to lend. This leads to a further fall in spending and investment.
• Real interest rates increase. Normally bank rates are stuck at 0%. Therefore, deflation of
2.6% means the real interest rate in Japan is quite high for the economic situation. This
makes it attractive to save money and unattractive to borrow.
• Deflation and falling demand also reduce confidence. Lower confidence reduces investment
and consumer spending.

Potential benefits of deflation

On the right, deflation is caused by increased productivity – it enables lower prices and higher
output.

The right kind of deflation will cause:

1. Deflation from increased efficiency and lower costs of production. The right
kind of deflation involves lower prices through increased productivity and better
technology. A-Level students should think of the Aggregate Supply curve shifting to
the right – which both lowers the price level and increases real GDP.
2. Improved international competitiveness. If one country has deflation, and others
have inflation, then that country will become more internationally competitive, leading
to a rise in exports. During Japan’s deflation, they saw strong exports – which helped
offset the fall in consumer spending (though it still wasn’t enough). However, if there
is a region-wide period of deflation – e.g., Europe in 2014, then you are not getting
this competitive advantage.
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