Deflation - A Level Economics
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Deflation Deflation is a period when the general pri ce level falls i.e. the cost of a basket of goods and services is becoming less expensive. It is normally associated with falling level of AD leading to a negative output gap where actual GDP < potential GDP. But deflation can also be caused by an increase in a nation’s productive potential, which leads to an excess of aggregate supply over demand. “Deflation is a sustained period over which the g eneral price level is falling. But just as there are many different strains of influenza, some of them lethal, and some of them producing just temporary discomfort, so it is with deflation. And just as a bad cold may generate 'flu-like symptoms, so economies may exhibit some of the symptoms of deflation without suffering from the virus.” Source: Charles Bean, Bank of England Chief Economist, October 2002 Possible Economic Costs of De flation o Holding back on spending: Consumers may opt t o postpone demand if they expect prices to fall further in the future. If they do, they might find prices are 5 or 10% cheaper in 6 months. o Debts increase: The real value of debt rises when the general price level is falling and a higher real debt mountain can be a drag on consumer confidence and people’s willingness to spend. o The real cos t of b orrowi ng inc reases: Real interest rates will rise if nominal rates of interest do not fall in line with prices – another factor driving spending lower. For example UK policy interest rates were slashed to 0.5% between 2008-09 but realistically they cannot go any lower. If RPI and CPI inflation both become negative, the real cost of borrowing increases. o Lower profit margins: Company profit margins come under pressure unless costs f all further than prices paid by consumers – this can lead to higher unemployment as firms seek to reduce their costs by shedding labour. o Confidence and saving : Falling asset prices such as price deflation in the housing market hit personal sector wealth and confidence – leading to further declines in aggregate demand. General Price Level Real National Income AD1 SRAS Pe Ye LRAS Yfc AD2 Y2 P2 General Price Level AD1 SRAS P1 Y1 LRAS1 LR AS2 YFC2 Y2 AD2 P2 A fall in aggregate demand A rise in long run aggregate supply
Transcript of Deflation - A Level Economics
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DeflationDeflation is a period when the general price level falls i.e. the cost of a basket of goods andservices is becoming less expensive. It is normally associated with falling level of AD leading to anegative output gap where actual GDP < potential GDP. But deflation can also be caused by anincrease in a nation’s productive potential, which leads to an excess of aggregate supply over
demand.
“Deflation is a sustained period over which the general price level is falling. But just as there aremany different strains of influenza, some of them lethal, and some of them producing just temporarydiscomfort, so it is with deflation. And just as a bad cold may generate 'flu-like symptoms, soeconomies may exhibit some of the symptoms of deflation without suffering from the virus.”
Source: Charles Bean, Bank of England Chief Economist, October 2002
Possible Economic Costs of Deflation
o Holding back on spending: Consumers may opt to postpone demand if they expect pricesto fall further in the future. If they do, they might find prices are 5 or 10% cheaper in 6 months.
o Debts increase: The real value of debt rises when the general price level is falling and ahigher real debt mountain can be a drag on consumer confidence and people’s willingness tospend.
o The real cost of borrowing increases: Real interest rates will rise if nominal rates of interestdo not fall in line with prices – another factor driving spending lower. For example UK policyinterest rates were slashed to 0.5% between 2008-09 but realistically they cannot go anylower. If RPI and CPI inflation both become negative, the real cost of borrowing increases.
o Lower profit margins: Company profit margins come under pressure unless costs fall furtherthan prices paid by consumers – this can lead to higher unemployment as firms seek toreduce their costs by shedding labour.
o Confidence and saving: Falling asset prices such as price deflation in the housing market hitpersonal sector wealth and confidence – leading to further declines in aggregate demand.
GeneralPriceLevel
Real National Income
AD1
SRAS
Pe
Ye
LRAS
Yfc
AD2
Y2
P2
GeneralPriceLevel
AD1SRAS
P1
Y1
LRAS1 LR AS2
YFC2Y2
AD2
P2
A fall in aggregate demand A rise in long run aggregate supply
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Benign Deflation
Deflation is not necessarily bad! If falling prices are caused by higher productivity, as happened inthe late 19th century, then it can go hand in hand with robust growth. On the other hand, if deflationreflects a slump in demand and persistent excess capacity, it can be dangerous, as it was in the1930s, triggering a downward spiral of demand and prices. If the falling prices are simply the result ofimproving technology or better managerial practices, that is fine.
Malign Deflation
Malign deflation occurs when prices fall because of a structural lack of demand which creates hugeexcess capacity in an economic system. If there is a slump in demand, companies go out of businessand sack people, and hence demand falls again – the negative multiplier effect starts to have itseffect.
John Maynard Keynes on deflation
A recession puts downward pressure on prices and wages – but wages tend to be sticky – so ifprices are falling but wages are not, business profits will suffer and this could lead to a huge rise in
unemployment.Irving Fisher on deflation
Central banks can only cut nominal interest rates to zero per cent but if prices and wages are falling,real interest rates will rise and the real value of existing business and household debt will increase –there is a strong incentive for people to use any rise in real incomes to save and pay down some oftheir debts rather than spend on new goods and services.
RPI for audio visual equipment and toys, photographic & sports goods
Price deflation in a selection of products
Audio-visual equipment Toys, photographic and sports goodsSource: Reuters EcoWin
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
m i l l i o n s
-22.5
-20.0
-17.5
-15.0
-12.5
-10.0
-7.5
-5.0
-2.5
0.0
2.5
5.0
A n n u a l %
c h a n g e i n r e t a i l p r i c e s ( m i l l i o n s )
-22.5
-20.0
-17.5
-15.0
-12.5
-10.0
-7.5
-5.0
-2.5
0.0
2.5
5.0
Audio visual equipment
Toys, photographic and sports goods
What is causing price deflation in the UK economy?
A number of factors have combined to cause official measures of inflation to become negative –some are demand-side (AD) and others have affected short run aggregate supply (SRAS).
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(i) Increasing levels of spare capacity due to the recession. The output gap has becomenegative and many businesses have opted to discount prices to improve cash flow and sellexcess stocks. The recession has led to a collapse in pricing power for manufacturers andretailers
(ii) A fall in the world prices of foodstuffs and cheaper oil and gas prices.
(iii) An appreciation of the exchange rate during 2009 that has helped to cut the costs of imports.
(iv) A decision by the government in November 2007 to temporarily cut the rate of VAT from17.5% to 15%.
(v) Lower mortgage rates because of the relaxation of monetary policy by the Bank of England.
(vi) Falling prices for raw materials and components and evidence of pay cuts in many industries
Macroeconomic polic ies at a time of deflation
A number of options are available for policy-makers when an economy tilts into deflation.
Monetary Policy• Interest rates: Deep cuts in interest rates can be made to stimulate the demand for money
and thereby boost consumption. As we shall see in the chapter on monetary policy, mostcentral banks around the world have responded to the global recession by slashing officialpolicy rates, in the UK from 5.5% to 0.5% in little more than a year. But this is not always aneffective strategy for reducing the risks of deflation:
o If consumer confidence is low, the impact of a monetary stimulus might be weak aspeople are more likely to save any added income to enable them to pay offaccumulated debt.
o If asset prices are falling, the demand for cash savings will remain high – therefore
consumption may not respond to lower interest rates.
o There are limits to how far monetary policy can go in boosting demand becausenominal interest rates cannot fall below zero.
• Quantitative Easing – The Bank of England started this process in March 2009. To some itis best explained as the process of printing money in the hope that, by injecting it into theeconomy, people and companies will be more likely to spend. If they are more likely to spend,there is a chance that output and employment will respond. Covered in more detail in thechapter on monetary policy.
Fiscal Policy
A fiscal expansion of AD can come directly through higher government spending and/or an increasein public sector borrowing. Secondly the threat of deflation might be reduced through lower directtaxes to boost household disposable incomes. Both of these strategies seek to boost incomes andinject extra spending power into the circular flow of income and spending.
The tax cuts might be announced as temporary to deal with a specific deflationary threat. But againthere may be limits to the effectiveness of f iscal policy in these circumstances:
o There are long term consequences for the size of the national debt
o Low consumer and business confidence might again reduce the impact of any fiscal stimulus.
