Deflation

Question 1

Deflation

Answer 1

A persistent fall in the general price level

Question 2

2 Types of deflation

Answer 2

1. Malevolent deflation (bad)

2. Benign deflation (good)

Question 3

Malevolent deflation

Answer 3

Bad

1. Falling prices resulting from a significant downturn in economic activity
2. This causes a collapse of AD, resulting in a fall in output and a rise in unemployment

Question 4

Benign deflation

Answer 4

Good

1. Falling prices resulting from technological advances and improved productivity across the economy
2. This improves the economy’s supply-side, causing the SRAS and LRAS to increase
3. The price level falls but the output and employment rise

Question 5

Cost of deflation (Purchases)

Answer 5

1. Consumers may postpone purchases -> C decreases -> AD decreases -> actual economic growth decreases -> output decreases -> firms need fewer workers -> cyclical unemployment increases -> Yd decreases -> C further decreases -> AD decreases again -> negative multiplier effect -> economic growth decreases further -> can lead to a recession

Question 6

Cost of deflation (Weak)

Answer 6

1. Deflation is often associated with a weak economy
   a)
   People believe there is a weak economy -> decrease in consumer and business confidence -> C + L decreases -> AD decreases
   b)
   If the Bank of England decreases I/r to try to boost the economy, consumers and businesses may not spend due to low confidence (liquidity trap)

Question 7

Cost of deflation

Answer 7

1. Deflation increases the real value of savings
2. Negative impact on debtors, e.g. homeowners
3. Decrease in FDI
   a) FDI : Foreign Direct Investment
   b) If other countries lose confidence in the UK -> decrease FDI -> LRAS does not increase as quickly

Question 8

Benefits of deflation

Answer 8

1. Increase in real income (Y) + purchasing power of money -> consumers can afford to buy more -> increases Standart of living (SoL)
2. Increase in international competitiveness
   Decrease in price level -> increase Price competitiveness of UK g + s -> increases D for UK X, decreases in D for M into UK -> increases AD -> increases in actual economic growth -> increases output -> increases D of labour -Y decreases cyclical unemployment -> increases Yd -> increases C -> increases AD again -> positive multiplier effect
3. Policies used to decrease the deflation may lead to benefits. E:g. the BoE may decrease I/r -> decrease cost of borrowing -> increases C -> increases SoL

Question 9

Is deflation always bad? It depends on…

Answer 9

1. The rate/magnitude of the deflation
2. The duration of the deflation
3. Wether deflation is worse than inflation, e.g. it might be preferable to high inflation
4. The cause/type of the deflation
5. What I happening in other economies -> relative deflation
6. The flexibility of the Gort/Central Bank to reduce the deflation