Deflation

Question 1

Deflation

Answer 1

Deflation occurs when there is a fall in prices; it means a negative inflation rate. (e.g. CPI = -0.5%)

Question 2

Deflation caused by increased productivity

Answer 2

• If there is a significant increase in productivity, e.g. better technology, then LRAS will shift to the right.
• This can cause a fall in the price level, but there will also be an increase in Real GDP. This is beneficial for the economy.

Question 3

Deflation caused by falling AD

Answer 3

• Lower AD has caused a fall in the price level, but has also caused a fall in Real GDP.
• This kind of deflation can be very damaging to the economy.

Question 4

Problems of Deflation

Answer 4

1. Lower spending If prices are falling - consumers will be more reluctant to spend because they feel that prices will be lower in the future. This delay in spending will reduce AD and cause lower economic growth.
2. Liquidity trap - Monetary policy becomes ineffective because interest rates cannot fall below zero, meaning real interest rates will be too high.
3. Real wage unemployment - Workers are reluctant to accept a cut in nominal wages, therefore firms may have to increase real wages by more than they would like. This could increase real wage unemployment.
4. Real value of debt will increase - This can reduce AD further as firms and consumers struggle to pay the increasing debt burden.