Causes & Consequences of Deflation (Cambridge (CIE) O Level Economics)

Revision Note

Author

Steve Vorster

Expertise

Economics & Business Subject Lead

Demand-side 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

Demand-side deflation (bad deflation)

Demand-side deflation is caused by a fall in total (aggregate) demand in the economy
Total (aggregate) demand is the sum of all expenditure 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 the total demand in the economy leading to a decrease in the general price level
- Demand-side deflation has occurred

The Consequences of Demand-side Deflation

Unemployment	Consumers Lose Confidence	Debt
With a decrease in output, fewer workers are required and so unemployment increases	With falling output and rising unemployment, households lose confidence choosing to save instead of spend Consumption falls and rGDP reduces even more	Debt feels more burdensome as the value of any debt is worth more Real cost of borrowing increase 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	Exports
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)

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
- General price levels fall
- National output (rGDP) increases

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 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 boosts international competitiveness and exports increase

Exam Tip

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/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/services so unemployment will decrease.

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