Deflation

Deflation is a period when the general price level falls i.e. the cost of a basket of goods and services is becoming less expensive. It is normally associated with falling level of AD leading to a negative output gap where actual GDP < potential GDP. But deflation can also be caused by an increase in a nations productive potential, which leads to an excess of aggregate supply over demand.
A fall in aggregate demand
LRAS General Price Level General Price Level

A rise in long run aggregate supply

LRAS1 LRAS2

Pe P2

P1 P2

SRAS
AD1

SRAS

AD1

AD2

AD2 Y2 Ye Yfc
Real National Income

Y1

Y2

YFC2

Deflation is a sustained period over which the general price level is falling. But just as there are many different strains of influenza, some of them lethal, and some of them producing just temporary discomfort, so it is with deflation. And just as a bad cold may generate 'flu-like symptoms, so economies may exhibit some of the symptoms of deflation without suffering from the virus. Source: Charles Bean, Bank of England Chief Economist, October 2002 Possible Economic Costs of Deflation o o 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 peoples 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 another factor driving spending lower. For example UK policy interest rates were slashed to 0.5% between 2008-09 but realistically they cannot go any lower. If RPI and CPI inflation both become negative, the real cost of borrowing increases. Lower profit margins: Company profit margins come under pressure unless costs fall further than prices paid by consumers 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.

Benign Deflation Deflation is not necessarily bad! 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 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 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 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.

Price deflation in a selection of products

RPI for audio visual equipment and toys, photographic & sports goods 5.0 2.5 Toys, photographic and sports goods 5.0 2.5 0.0 -2.5 -5.0

Annual % change in retail prices (millions)

0.0 -2.5 -5.0 -7.5 -10.0 -12.5 -15.0 -17.5 -20.0 -22.5 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 Audio visual equipment

-10.0 -12.5 -15.0 -17.5 -20.0 -22.5

Audio-visual equipment

Toys, photographic and sports goods

Source: Reuters EcoWin

What is causing price deflation in the UK economy? A number of factors have combined to cause official measures of inflation to become negative some are demand-side (AD) and others have affected short run aggregate supply (SRAS).

millions

-7.5

(i)

Increasing levels of spare capacity due to the recession. The output gap has become negative and many businesses have opted to discount prices to improve cash flow and sell excess stocks. The recession has led to a collapse in pricing power for manufacturers and retailers A fall in the world prices of foodstuffs and cheaper oil and gas prices. An appreciation of the exchange rate during 2009 that has helped to cut the costs of imports. A decision by the government in November 2007 to temporarily cut the rate of VAT from 17.5% to 15%. Lower mortgage rates because of the relaxation of monetary policy by the Bank of England. Falling prices for raw materials and components and evidence of pay cuts in many industries

(ii) (iii) (iv) (v) (vi)

Macroeconomic policies at a time of deflation A number of options are available for policy-makers when an economy tilts into deflation. Monetary Policy Interest rates: Deep cuts in interest rates can be made to stimulate the demand for money and thereby boost consumption. As we shall see in the chapter on monetary policy, 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% in little more than a year. But this is not always an effective strategy for reducing the risks of deflation: o 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.

o o

Quantitative Easing The Bank of England started this process in March 2009. 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. Covered in more detail in the chapter on monetary policy.

Fiscal Policy A fiscal expansion of AD can come directly through higher government spending and/or an increase in public sector 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: o o 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.