Price level : Deflation

Question 1

when does deflation occur?

Answer 1

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 %

Question 2

what can cause deflation?

Answer 2

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

Question 3

what is demand side deflations (bad deflation)

Answer 3

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

Question 4

draw a demand side deflation diagram
diagram analysis

Answer 4

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

Question 5

what are the consequences of demand side deflation?

Answer 5

government challenges
consumers lose confidence
debt
firms lose confidence
bankruptcies
exports

Question 6

The Consequences of Demand-side Deflation-government challenges

Answer 6

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

Question 7

The Consequences of Demand-side Deflation-consumers lose confidence

Answer 7

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

Question 8

The Consequences of Demand-side Deflation-debt

Answer 8

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%

Question 9

The Consequences of Demand-side Deflation- firms lose confidence

Answer 9

Falling output and falling prices cause firms to lose confidence and so they delay investment, further reducing rGDP

Question 10

The Consequences of Demand-side Deflation- bankruptcies

Answer 10

Falling output and falling prices reduce the profits of firms
Some firms will be unable to continue and will go out of business

Question 11

The Consequences of Demand-side Deflation-
export

Answer 11

Persistently falling prices can prove attractive to foreigners and the level of exports may increase (this helps offset some of the reduction in rGDP)

Question 12

how is supply side inflation caused ?

Answer 12

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

Question 13

draw supply side deflation diagram
diagram analysis

Answer 13

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

Question 14

The Consequences of Supply-side Deflation-what are the consequences of supply side deflation?

Answer 14

unemployment
consumers gain confidence
debt
firms gain confidence
exports

Question 15

The Consequences of Supply-side Deflation-unemployment

Answer 15

With a decrease in costs, the output of firms increases. More workers are required and so unemployment falls

Question 16

The Consequences of Supply-side Deflation-consumers gain confidence

Answer 16

With rising output and falling price levels, households become more confident and the consumption increasing - increasing rGDP even more

Question 17

The Consequences of Supply-side Deflation-debt

Answer 17

Debt still feels more burdensome, as the value of any debt is worth more

Question 18

The Consequences of Supply-side Deflation-firms gain confidence

Answer 18

Rising output and falling costs of production cause firms to gain confidence and increase investment, thereby increasing rGDP

Question 19

The Consequences of Supply-side Deflation-exports

Answer 19

Persistently falling prices boost international competitiveness and exports increase

Question 20

Exam tip

Answer 20

Understanding the cause of deflation is vital to analysing the consequences of it.

Falling prices caused by a recession are not good for an economy. In this scenario, national output is falling, which means that fewer workers will be required to produce goods and services, so unemployment will increase.

Falling prices caused by an increase in supply are good for an economy. In this scenario, national output is rising, which means that more workers will be required to produce goods and services, so unemployment will decrease.