Deflation is a sustained fall in the general price level: the inflation rate is below zero.
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The points to remember
- Disinflation is different: inflation falling from 6% to 2% means prices still rise, more slowly.
- Bad deflation: AD falls, so output falls too.
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Not all deflation is bad. Falling costs can also bring prices down.
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Remember it as: Bad: AD left, less output. Good: SRAS right, more output.
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Why do governments fear demand-side deflation?
The deflationary spiral
Prices fall
Shoppers expect them to fall further.
Spending is delayed
Why buy a car today if it is cheaper next year?
Firms cut output and jobs
Sales fall, profits fall, workers are laid off.
AD falls again
Lower incomes mean even less spending, and prices fall again.
What deflation costs
| Cost of deflation | Why it happens |
|---|---|
| Real value of debt rises | Incomes and prices fall but debts do not: borrowers cut spending; some go bankrupt |
| Cyclical unemployment | Money wages are sticky, so real wages rise; firms hire fewer workers |
| Policy stops working | Interest rates cannot fall much below zero, so monetary policy has little room |
| Redistribution | Savers and lenders gain; borrowers lose |
Paper 1 asked this in the specimen paper, as part (a) for 10 marks.
Explain two possible causes of deflation.
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Animated graph
Watch the graph build step by step in study mode.
What the diagram must show
- Axes: price level up, real GDP across.
- Bad deflation: AD left, PL and Y both fall.
- Good deflation: SRAS right, PL falls, Y rises.
How the 10 marks are given
| Marks | What your answer needs |
|---|---|
| 9–10 | Theory fully explained, terms used correctly all the way through, the diagram included and fully explained |
| 7–8 | Theory explained, terms mostly right, the diagram included and explained |
| 5–6 | Theory partly explained, some terms, the diagram included |
| 1–4 | Theory only described or stated; few relevant terms |