9. Economic Performance - Deflation, Causes & Consequences

Question 1

When does deflation occur in an economy?

Answer 1

When there is negative inflation - not the same as a decrease in inflation

Question 2

Which type of deflation is worse for the economy and why?

Answer 2

Demand-side deflation is far worse for the economy than supply-side deflation as it may result in a deflationary spiral. Supply-side deflation in the short run may actually be reasonably beneficial.

Question 3

What are the three main main reasons an economy may fall into a deflationary spiral?

Answer 3

If people see prices falling they will hold back on consumption hoping to get things cheaper later on - AD falls further - impact of expectations , works in reverse for inflationReduces the effect of interest rates - ppl incentivised to save bc even if interest =0% real interest = interest - real inflation0% - -2% = + 2% interest Real term values of debt increases as people’s wages and the cost of living decrease.

Question 4

What are the consequences of deflation to individuals and the whole economy?

Answer 4

Debts increase: The real value of debt rises with deflation and higher real debts can be a big drag on consumer confidenceThe real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line with prices.Confidence and saving: Falling asset prices such as price deflation in the housing market hits personal sector wealth and confidenceDeflation can make exporters more competitive eventually – but this often comes at a cost i.e. higher unemployment in short term