Deflation

Defined as a sustained fall in the general level of prices, deflation is not necessarily harmful, but there there is a danger that it could have disastrous economic consequences.

Causes of deflation

Deflation is in almost all cases a side effect of a collapse of aggregate demand--a drop in spending so severe that producers must cut prices in order to find buyers.The economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending--namely, recession, rising unemployment, and financial stress.

Effects of deflation

Immediate effects

Deflation tends to make consumers reduce their purchases in the expectation of being able to buy more cheaply at a later date. That can have a depressing effect upon demand and lead to a reduction of output. Another potentially important effect is to require borrowers to repay more than they had borrowed (for example, if prices declined by 20 percent, a farmer who had previously borrowed £100 to buy ten pigs would have to repay the equivalent of twelve pigs). The resulting loss to borrowers may be balanced by gains to lenders, but if borrowers are forced to default, the resulting disruption can lead to a further reduction in output. Another effect is to require employers to pay their employees the same wages despite a reduction in income from their employees' output. Unless there is a compensating wage reduction, that may result in a reduction in employment and another reduction in output.

The "deflationary spiral"

Given time, adjustments could be made to limit the resulting output losses, but a sudden and unexpected deflation could result in losses that feed upon themselves by reinforcing the tendencies that produced them. For example the output loss from the deferrment of purchases could lead to an increase in unemployment which could prompt a further reduction in spending and thus a further increase in unemployment.

Policy responses

Historical experience

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