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

• 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)

• 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