DEFLATION
Pushkar Srinivas
Lesson objectives
BEING ABLE TO IDENTIFY THE IDENTIFY THE CONSEQUENCES POLICIES AVAILABLE TO
CAUSE OF DEFLATION OF DEFLATION CONTROL DEFLATION
WHAT IS DEFLATION?
◦Deflation occurs when there is a fall in the average
price level of goods/services in an economy as
measured by the consumer price index (CPI)
◦Deflation only occurs when the percentage change in
prices falls below zero %
◦Deflation can be caused by either demand-side or
supply-side factors
◦The two different causes of deflation have very
different consequences for the economy
THE CAUSES OF DEFLATION
◦Supply-side deflation(good deflation) is caused by
increases in the productive capacity of the economy
◦This is brought about by any increase in the
quantity/quality of the factors of productionIt
effectively creates a condition of excess supply in the
economy
◦General price levels fall
◦National output (rGDP) increases
Price
AD There is a decrease
AS1
AS in price level and
increase in output.
P That is why it is
P1 good deflation
AD
May reduce current
account deficit as
Q Q1
Output more goods can be
exported
◦Demand-side deflation(Bad deflation) is caused by a fall in
total (aggregate) demand in the economy
◦Total (aggregate) demand is the sum of all expenditure in the
economy as measured by the real gross domestic product
(rGDP)
◦rGDP = Consumption (C) + Investment (I) + Government
spending (G) + Net Exports (X-M)
◦If any of the four components of rGDP decrease, there will
possibly be a decrease in the total demand in the economy
leading to a decrease in the general price level
◦Demand-side deflation has occurred
AD
AD1 There is a fall in
price level which
P is deflation and
a fall in the
P1 output
That is why
it is bad
deflation
Q1 Q
Unemployment Consumers Lose
Debt
Confidence
With a decrease in
With falling output & rising
Debt feels more burdensome Consequence
output, fewer workers are as the value of any debt is
required & so unemployment
unemployment, households
lose confidence choosing to
worth more. Real cost of s of bad
increases borrowing increase as real
save instead of spend.
Consumption falls
interest rates rise when the deflation
price level falls e.g. if
& rGDP reduces even more
interest rates are 1.5% & the
inflation rate is –1.5%, then
the real interest rate is 3%
Firms Lose Bankruptcies Exports
Confidence
Falling output & falling prices Falling output & falling Persistently falling prices can
cause firms to lose prices reduce the profits of prove attractive to
confidence & so they delay firms. Some firms will be foreigners & the level of
investment, further reducing unable to continue & will go exports may increase (this
rGDP out of business helps offset some of the
reduction in rGDP)
Consumers Gain
Unemployment Debt
Confidence
Consequence
s of good
With a decrease in costs, With rising output & falling
the output of firms
Debt still feels
price levels, households more burdensome as the
deflation
increases. More workers become more value of any debt is worth
are required & so confident & consumption more
unemployment falls increasing - increasing
rGDP even more
Firms Gain Confidence Exports
Rising output & falling Persistently falling prices
costs of production cause boosts international
firms to gain confidence & competitiveness &
increase investment, exports increase
thereby increasing rGDP
POLICIES TO CONTROL DEFLATION
Broad Policy Type
Specific Policy Explanation
Expansionary Fiscal Government increases ex Defence firms receive more orders from the government → total demand
Policy penditure on national increases → deflation is improved/eliminated
defence
Expansionary Fiscal Government decreases p Households have more discretionary income → consumption
Policy ersonal income tax increases →total demand increases → deflation is improved/eliminated
Expansionary The Central Bank lowers Household repayments on existing loans fall → Households have more
Monetary Policy interest rates discretionary income → consumption increases → total demand increases →
deflation is improved/eliminated
THANK YOUU