It is normally associated with falling AD causing a negative output gap (actual GDP < potential GDP)
Deflation can be caused by an increase in productive potential, which leads to an excess of aggregate supply over demand
AD-AS diagrams showing two possible causes of deflation are shown below
Possible Economic Costs of Deflation
Holding back on spending: Consumers may opt to postpone demand if they expect prices to fall further in the future. If they do, they might find prices are 5 or 10% cheaper in 6 months.
Debts increase: The real value of debt rises when the general price level is falling and a higher real debt mountain can be a drag on consumer confidence and people’s willingness to spend.
The real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line with prices. For example UK policy interest rates were slashed to 0.5% in 2009 but realistically they cannot go any lower. If inflation is negative, the real cost of borrowing increases.
Lower profit margins: Lower prices can mean reduced revenues and profits for businesses - this can lead to higher unemployment as firms seek to reduce their costs by shedding labour.
Confidence and saving: Falling asset prices such as price deflation in the housing market hit personal sector wealth and confidence – leading to further declines in aggregate demand.
If falling prices are caused by higher productivity, as happened in the late 19th century, then it can go hand in hand with robust growth. On the other hand, if deflation reflects a slump in demand and persistent excess capacity, it can be dangerous, as it was in the 1930s, triggering a downward spiral of demand and prices. If the falling prices are simply the result of improving technology or better managerial practices, that is fine.
Malign deflation occurs when prices fall because of a structural lack of demand which creates huge excess capacity in an economic system. If there is a slump in demand, companies go out of business and sack people, and hence demand falls again – the negative multiplier effect starts to have its effect.
John Maynard Keynes on deflation
A recession puts downward pressure on prices and wages – but wages tend to be sticky downwards (people resist having their pay cut)
So if prices are falling but wages are not, business profits will suffer and this could lead to a huge rise in unemployment.
Irving Fisher on deflation
Central banks can only cut nominal interest rates to zero per cent but if prices and wages are falling, real interest rates will rise and the real value of existing business and household debt will increase
During a period of recession and deflation, there is a strong incentive for people to use any rise in real incomes to save and pay down some of their debts rather than spend on new goods and services.
Macroeconomic policies at a time of deflation
A number of options are available for policy-makers when an economy tilts into deflation.
Interest rates: Deep cuts in interest rates can be made to stimulate the demand for money and thereby boost consumption. Most central banks around the world have responded to the global recession by slashing official policy rates, in the UK from 5.5% to 0.5%. But this is not always an effective strategy for reducing the risks of deflation:
If consumer confidence is low, the impact of a monetary stimulus might be weak as people are more likely to save any added income to enable them to pay off accumulated debt.
If asset prices are falling, the demand for cash savings will remain high – therefore consumption may not respond to lower interest rates.
There are limits to how far monetary policy can go in boosting demand because nominal interest rates cannot fall below zero.
Quantitative Easing – The Bank of England started this process in March 2009 and expanded it in October 2011. In total (so far) QE has involved £275bn of asset purchases designed to boost lending by the banking system. To some it is best explained as the process of printing money in the hope that, by injecting it into the economy, people and companies will be more likely to spend. If they are more likely to spend, there is a chance that output and employment will respond.
Keynesian economists believe that fiscal policy is a more effective instrument of policy when an economy is stuck in a deflationary recession
The key Keynesian insight is that a market system does not have powerful self-adjustments back to full-employment after there has been a negative economic shock
Keynes talked of persistent under-employment equilibrium – an economy operating in semi-permanent recession leading a persistent gap between actual demand and the potential level of GDP. Keynes argued that this justified an exogenous injection of aggregate demand as a stimulus to get an economy on the path back to full(er) employment and to prevent deflation.
A fiscal expansion of AD can come directly through higher government spending and/or an increase in borrowing. Secondly the threat of deflation might be reduced through lower direct taxes to boost household disposable incomes. Both of these strategies seek to boost incomes and inject extra spending power into the circular flow of income and spending.
The tax cuts might be announced as temporary to deal with a specific deflationary threat. But again there may be limits to the effectiveness of fiscal policy in these circumstances:
There are long term consequences for the size of the national debt
Low consumer and business confidence might again reduce the impact of any fiscal stimulus.