A LevelEconomicsAQARevision NotesThe National & International Economy11. Economic PerformancePrice Level: Deflation

Price Level: Deflation (AQA A Level Economics)

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Lorraine

Written by: Lorraine

Reviewed by: Steve Vorster

The Consequences of Deflation

  • 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 %

  • 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

1. Demand-side deflation (bad deflation) 

  • 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

Diagram: Demand Side Deflation

Diagram of demand side deflation for A level Economics
Aggregate demand (AD) has fallen leading to a reduction in the average price level (AP) and a fall in output

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 

The Consequences of Demand-side Deflation

Government Challenges

Consumers Lose Confidence

Debt

  • 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

  • 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

  • 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%

Firms Lose Confidence

Bankruptcies

Export

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

  • Falling output and falling prices reduce the profits of firms

  • Some firms will be unable to continue and will go out of business

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

2. Supply-side Deflation

  • 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

Diagram: Supply Side Deflation

3-3-4---supply--side-deflation
Short-run aggregate supply (SRAS) has increased, leading to a reduction in the average price level (AP)

Diagram analysis

  • The initial macroeconomic equilibrium is at AP Y

  • Any factor which causes an increase in the SRAS will result in the SRAS curve shifting right from SRAS → SRAS1

  • This shift causes a fall in average price levels from AP → AP1

  • The new macroeconomic equilibrium is now at AP1 Y1

  • Supply-side deflation has occurred 

The Consequences of Supply-side Deflation

Unemployment

Consumers Gain Confidence

Debt

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

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

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

Firms Gain Confidence

Exports 

 

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

  • Persistently falling prices boost international competitiveness and exports increase

 

Examiner Tips and Tricks

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.

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    Lorraine

    Author: Lorraine

    Expertise: Economics Content Creator

    Lorraine brings over 12 years of dedicated teaching experience to the realm of Leaving Cert and IBDP Economics. Having served as the Head of Department in both Dublin and Milan, Lorraine has demonstrated exceptional leadership skills and a commitment to academic excellence. Lorraine has extended her expertise to private tuition, positively impacting students across Ireland. Lorraine stands out for her innovative teaching methods, often incorporating graphic organisers and technology to create dynamic and engaging classroom environments.

    Steve Vorster

    Author: Steve Vorster

    Expertise: Economics & Business Subject Lead

    Steve has taught A Level, GCSE, IGCSE Business and Economics - as well as IBDP Economics and Business Management. He is an IBDP Examiner and IGCSE textbook author. His students regularly achieve 90-100% in their final exams. Steve has been the Assistant Head of Sixth Form for a school in Devon, and Head of Economics at the world's largest International school in Singapore. He loves to create resources which speed up student learning and are easily accessible by all.