3.10 - Deflation
The definition and calculation of deflation
Deflation occurs when there is a sustained decrease in the average price level across an economy. This means that the inflation rate becomes negative, indicating that prices are falling overall compared to a previous period.
The deflation rate is calculated using changes in the Consumer Prices Index (CPI), which measures the average change in prices of a basket of goods and services.
Where:
- New CPI = CPI value for the current year
- Old CPI = CPI value for the previous year
A negative result indicates deflation, showing that prices have decreased.
Worked example - Calculating the deflation rate
The CPI in 2022 was 142.50, and in 2023 it fell to 138.75. Calculate the deflation rate for 2023.
Step 1: Identify the values
- Old CPI (2022) = 142.50
- New CPI (2023) = 138.75
Step 2: Apply the formula
Step 3: Perform the calculation
The causes of deflation
Deflation can arise from shifts in key economic factors that affect the overall price level. These causes are linked to changes in demand or supply within the economy.
Main causes of deflation
- Sustained decrease in aggregate demand - This shifts the aggregate demand (AD) curve leftward, leading to a fall in both real gross domestic product (GDP) and the average price level.
- Increase in aggregate supply - This can cause a falling average price level accompanied by an increase in real output. Sometimes called "good deflation," this term is misleading because deflation is hard to reverse once people expect prices to keep falling.
The costs of deflation
Deflation brings several negative consequences for households, firms, and the wider economy. These effects can create a cycle that worsens economic conditions.
Key costs of deflation
- Delayed consumer purchases - People postpone buying durable goods, like electronics, expecting even lower prices in the future. This further reduces the average price level.
- Falling firm revenues - Lower prices cut profits, leading firms to reduce costs by lowering wages, making workers redundant, or even going bankrupt.
- Decline in output and employment - Both the price level and real output decrease, resulting in higher unemployment.
- Rising real debt burdens - The value of existing debts increases in real terms, making households reluctant to borrow and spend, and firms hesitant to invest.
- Risk of banking crises - Households and firms may struggle to repay loans, creating non-performing loans that threaten banks.
- Low confidence and uncertainty - This discourages consumption and investment decisions.
- Deflationary spiral - Deflation can feed into more deflation, creating a vicious cycle.
- Resource misallocation - Prices lose their role in signalling scarcity, distorting incentives for producers and consumers.
- Limited policy responses - Monetary policy becomes ineffective at the zero lower bound (ZLB), where interest rates are already near zero, and fiscal policy may be constrained by high debt levels.
Comparing the relative costs of unemployment and inflation
The impacts of unemployment and inflation vary depending on economic conditions, social factors, and viewpoints. Unemployment often arises from deflationary pressures, while inflation can erode purchasing power.
Factors influencing the relative costs
- Socioeconomic impacts - Wealthy households with fixed-income assets suffer more from inflation, as it reduces the real value of their savings. In contrast, workers are often more affected by unemployment, prioritising job security over concerns about rising prices.
- Ideological perspectives - Monetarists, such as Milton Friedman, see inflation as a major issue because it distorts markets, the price mechanism, and resource allocation.
- Contextual considerations - High unemployment can lead to long-term social problems, while rapid inflation harms savings and economies reliant on exports.
Policymakers' perspectives on deflation and related challenges
Policymakers face difficulties in managing deflation, especially in balancing economic growth with price stability. They monitor various indicators to anticipate and respond to deflationary risks.
Key challenges for policymakers
- Predicting inflation in a growing economy - It is hard to determine when falling unemployment in an expanding economy will lead to rising inflation. Policymakers watch labour markets for signs of wage and price increases.
- Inflation targeting - Most aim for a 2% inflation rate rather than zero, partly due to measurement issues that may overestimate actual inflation.
- Discouraged workers phenomenon - During economic expansions, workers who had left the labour force (known as "workers on the sidelines") may rejoin, keeping wages stable despite low unemployment.
- Zero lower bound (ZLB) - This limits monetary policy effectiveness, as interest rates cannot be cut below zero (or very close to it) to stimulate the economy.
- Negative interest rates - Some central banks have adopted this policy to combat deflation, charging banks for holding reserves to encourage lending and spending.