Causes & Consequences of Deflation (Cambridge (CIE) O Level Economics)
Revision Note
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 |
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Firms Lose Confidence | Bankruptcies | Exports |
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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 |
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Firms Gain Confidence | Exports | |
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Examiner 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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