Price Level: Deflation (AQA A Level Economics)

• 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

1. Demand-side deflation (bad deflation) 

• Demand-side deflation is caused by a fall in total (aggregate) demand in the economy
• Aggregate demand is the sum of all expenditures 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 aggregate demand in the economy, leading to a decrease in the general price level
  • Demand-side deflation has occurred

Diagram: Demand Side Deflation

Aggregate demand (AD) has fallen leading to a reduction in the average price level (AP) and a fall in output

Diagram analysis

• The initial macroeconomic equilibrium is at AP Y
• Any factor which causes a reduction in one or more of the determinants of real GDP may cause the AD curve to shift left from AD₁ → AD₂
• This shift causes a fall in average price levels from AP to AP1
• The new macroeconomic equilibrium is now at AP₁ Y₁
• Demand-side deflation has occurred
   

The Consequences of Demand-side Deflation

Government Challenges	Consumers Lose Confidence	Debt
With a decrease in output, fewer workers are required and so unemployment increases Fiscal and monetary policy is less effective at combating deflation than inflation as consumers get into a habit of waiting for lower prices prior to making purchases	With falling output and rising unemployment, households lose confidence choosing to save instead of spend Consumption falls and rGDP reduces even more Consumers delay purchasing goods/services as they believe prices will be cheaper in a few weeks or months	Debt feels more burdensome as the value of any debt is worth more The real cost of borrowing increases as real interest rates rise when the price level falls e.g. if interest rates are 1.5% and the inflation rate is –1.5%, then the real interest rate is 3%
Firms Lose Confidence	Bankruptcies	Export
Falling output and falling prices cause firms to lose confidence and so they delay investment, further reducing rGDP	Falling output and falling prices reduce the profits of firms Some firms will be unable to continue and will go out of business	Persistently falling prices can prove attractive to foreigners and the level of exports may increase (this helps offset some of the reduction in rGDP)

2. Supply-side Deflation

• Supply-side 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 production
• It effectively creates a condition of excess supply in the economy
• Average price levels fall
• National output (rGDP) increases

Diagram: Supply Side Deflation

Short-run aggregate supply (SRAS) has increased, leading to a reduction in the average price level (AP)

Diagram analysis

• The initial macroeconomic equilibrium is at AP Y
• Any factor which causes an increase in the SRAS will result in the SRAS curve shifting right from SRAS → SRAS₁
• This shift causes a fall in average price levels from AP → AP₁
• The new macroeconomic equilibrium is now at AP₁ Y₁
• Supply-side deflation has occurred
   

The Consequences of Supply-side Deflation

Unemployment	Consumers Gain Confidence	Debt
With a decrease in costs, the output of firms increases. More workers are required and so unemployment falls	With rising output and falling price levels, households become more confident and the consumption increasing - increasing rGDP even more	Debt still feels more burdensome, as the value of any debt is worth more
Firms Gain Confidence	Exports
Rising output and falling costs of production cause firms to gain confidence and increase investment, thereby increasing rGDP	Persistently falling prices boost international competitiveness and exports increase