Deflation is defined as a general fall in the level of average prices. Falling prices are regarded as a significant macroeconomic problem as it is associated with other problems, including unemployment and falling national income.

Deflation can originate from both the demand and supply side.

Benign and malign deflation

Benign deflation

'Benign’ deflation is caused by improvements in production and supply which lower costs, and shifts the short run aggregate supply curve to the right. As its name suggests, benign deflation is not particularly problematic as it can provide a stimulus to consumption, and growth, and is associated with increased efficiency. The application of new technology can be a trigger for sustained reductions in average prices.

benign delflation

Given that improvements in technology are relatively gradual, it is unlikely that benign deflation will bring with the kind of problems associated with malign deflation.

Malign deflation

Deflation can also be ‘malign’ - caused by a reduction in aggregate demand. This is problematic as falling aggregate demand is likely to reduce employment and spending, and cause a recession. It will also reduce tax revenues to government, as well as increase government spending on unemployment benefits. This can worsen public sector finances rquiring increased borrowing, or raising taxes in the future.

malign delflation

In general, an extended period of deflation is problematic as it tends to mean that consumption is deferred as consumers wait for prices to fall further.

Delationary spiral

The two types can occur together in a deflationary spiral.

Deflationary spiral

US deflation

Deflation is a relatively rare phenomenon in the modern era, given that central banks target their monetary policy specifically to achieve low levels of inflation (usually around 2%). This means that monetary policy is, by default, mildly inflationary in its effect, and any episode of falling average prices would bring into play a fiscal stimulus to support 'expansionary' monetary policy.

However, there have been significant periods when deflation has persisted - especially during the inter-war years of the early 20th Century. The chart below identifies two deflationary periods in US history including the periods 1920-1921 and 1927-1933 (including the Great Depression years, 1930 to 1933.)

Deflation is closely associated with rising and persistent unemployment, both as a symptom of deflation and as a cause of it. Along with unemployment comes the likelihood of rising poverty and inequality.

Deflation and deferred consumption

A period of deflation is likely to become embedded given that the most significant effect of falling prices is, perhaps, that it encourage consumers to defer their current consumption in the hope that goods will get even cheaper in the longer run.

Video on deflation

Deflation and debt burdens

Debt burdens also increase as a fall in average prices increase real interest rates. The real interest rate is the nominal rate, less inflation, hence deflation causes real rates to rise. For example, if the nominal rate is 5% and deflation is (-) 2% then real rates are 7% (5% + 2%).

It is clear there is a significant macro-economic problem for those countries that experience malign deflation.

Aggregate demand

Why does the AD curve slope downwards?

Aggregate demand
Fiscal policy

How can fiscal policy help prevent deflation?

Fiscal policy
Monetary policy

Is monetary policy more effective at controlling deflation?

Monetary policy

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