Causes of deflation

24 September 2017 by Tejvan Pettinger

Readers Question: What is the cause of deflation?
Deflation involves a fall in the price level – a negative rate of inflation. From a
very basic standpoint, there are two main potential causes of deflation:

1. A fall in aggregate demand (AD)

2. A shift to the right of aggregate supply (AS) – i.e. lower costs of
production through improved technology.

Deflation usually occurs during a deep recession, when there is a sustained fall
in demand and output. This deflation may occur in the aftermath of credit
boom and bust or severe tightening of monetary policy/fiscal policy.
Monetarists emphasize the role of the money supply – falling money supply
and/or falling velocity of circulation causing a fall in the price level.

In rare circumstances, rapid growth in technology may enable lower prices,

whilst at the same time increasing output. This could be termed ‘benign
deflation’ as output increases. Also, a rapid drop in oil prices may cause a
negative inflation rate.

1. Deflation caused by falling aggregate demand (AD)

This simple AD/AS model shows that a fall in AD can cause a lower price level.

AD could fall due to :

 Fiscal austerity. If the government cut spending and cut the wages
of public sector workers – there will be a fall in spending and AD
will fall. This occurred in southern Europe in the Eurozone crisis
of 2012-16.
 Credit crunch/stock market fall. In the aftermath of the Wall
Street Crash 1929, many banks went bust. This caused a fall in the
money supply and a fall in bank lending. With contraction in
money supply and fall in spending, prices fell. Firms were trying
to cut prices to attract customers to buy surplus stock.
 The paradox of thrift. In a serious recession, people become
pessimistic about the future. Therefore, they are likely to increase
their personal savings and cut back on spending. This causes
lower demand and again firms may need to try and cut prices to
encourage sales. In Japan in the 2000s, there were periods of
deflation because customers were unwilling to spend.
 Debt deleveraging. After a credit bubble, people may be seeking to
pay off debts and have to reduce their spending.
 Overvalued exchange rate and high interest rates to maintain the
value of the currency.
 Tight monetary policy – higher interest rates.
Deflation spiral

Deflation can become a self-reinforcing loop. Falling prices create

circumstances for prices to continue falling.

 With falling prices – firms want to cut wages – lower wages lead
to less spending (AD) and lower costs.
 Falling prices lead to a decline in confidence, and therefore lower
spending and lower investment.
 Deflation leads to expectations of falling prices – people won’t
spend unless prices fall and they can delay spending until they do.
Deflation caused by lower costs
This is deflation caused by lower costs of production. This could be due to
lower oil prices or improved technology, e.g. development of computer chips
which enables price of manufactured goods to fall.
This is considered a ‘benign period of deflation because we get lower prices –
but output is also rising. We get the best of both worlds.

Examples of deflation

Deflation of the 1920s

In the 1920s, the UK experienced several periods of deflation. This was due to
several factors. One important factor was that the government tried to
maintain the value of Pound Sterling against the dollar at close to $4.85 (this
was the pre-war gold standard. The UK returned to this level in 1925). The
high pound, made imports cheaper (helping keep prices low). But, the
overvalued exchange rate also made UK exporters uncompetitive. Many firms
were forced to try and cut costs to retain their export markets. This created a
strong downward pressure on prices.

In addition, the economy faced:

 Relatively tight fiscal policy (trying to reduce budget deficit

through higher taxes, lower spending) After the end of the war,
the government cut spending quickly.

 Relatively tight monetary policy. Interest rates were kept high to

keep the value of the Pound high. Real interest rates were often
over 5% (compare that to negative real interest rates we see
today)
Deflation of 1930s

The UK experienced more deflation during the 1930s because of the extent of
the recession/great depression. The US also experienced a period of deflation.
One major cause of the US deflation was a fall in the money supply following
the failure of many banks in the aftermath of the Wall St crash and the Great
Depression.

Deflation of 2009 during the great recession

The UK experienced a period of temporary deflation during 2009 (if we use

the RPI method, which includes interest payments). However, CPI inflation
which excludes mortgage interest payments stayed positive.

The inflation picture in the UK was complicated:

 There was a sharp fall in output causing spare capacity and higher
unemployment. But, there was significant wage and price rigidity.
 The UK also experienced a sharp devaluation in the exchange rate
which tends to contribute to inflation (e.g. imports more
expensive)
 There was also substantial cost-push factors, such as rising oil
prices.
  Monetary policy was very loose. Interest rates cut to 0.5% and
from March 2009 a programme of Quantitative easing trying to
increase the money supply.
 Therefore, overall the recession did not cause actual deflation.
Deflation in the Eurozone

By contrast to the UK, countries in the periphery of the Eurozone, such as

Greece and (to a lesser extent Spain) have experienced deflation.

This is because

They cannot devalue in the Euro, so they are seeking to regain


competitiveness through internal devaluation. (cutting prices and
costs)
 Fiscal austerity – cutting spending, including cutting public sector
wages
 Due to the credit crunch, bank lending has fallen significantly;
this contributed to a fall in the money supply.
Why recession may not cause deflation

Periods of actual deflation are relatively rare. This is because prices and wages
can be sticky downwards. For example, if aggregate demand falls, firms may
like to reduce wages, but workers resist nominal wage cuts. Firms also might
keep prices the same, rather than cut them. Therefore, even in recessions,
inflation often stays positive. (though in a recession, rather confusingly we
may talk of ‘deflationary pressures’) (See: why we don’t have deflation at NY
Times for more on wage rigidity)
Deflation usually occurs during a prolonged and severe recession. It is a
recession where demand falls significantly, and eventually, firms start to cut
prices in a desperate attempt to boost spending. Also, if unemployment rises
sufficiently, then we may start to see nominal wage cuts which feed through
into lower prices.

Problems of deflation
9 December 2019 by Tejvan Pettinger
 Deflation is defined as a fall in the general price level. It is a
negative rate of inflation.
 The problem with deflation is that often it can contribute to lower
economic growth. This is because deflation increases the real
value of debt – and therefore reducing the spending power of
firms and consumers. Also, falling prices can discourage spending
as consumers delay their purchases.
 Deflation is not necessarily bad – especially if it is caused by
increased productivity. But often periods of deflation have led to
economic stagnation and high unemployment.
 Graph showing deflation in the 1920s and 1930s.

In the twentieth century, periods of deflation have been relatively rare. The
most significant period of deflation for the UK was in the 1920s and 1930s.
These decades (especially, the 1930s) were characterised by high
unemployment and economic depression.
Problems of Deflation
1. Discourages consumer spending. When there are falling
prices, this often encourages people to delay purchases because
they will be cheaper in the future. In particular, it can discourage
consumers from buying luxury goods / non-essential items, e.g.
flatscreen TV – because you could save money by waiting for it to
be cheaper. Therefore, periods of deflation often lead to lower
consumer spending and lower economic growth; (this, in turn,
creates more deflationary pressure in the economy). This fall in
consumer spending was a feature of the Japanese experience of
deflation in the 1990s and 2000s. (Japanese financial crisis).
2. Increase real value of debt. Deflation increases the real value
of money and the real value of debt. Deflation makes it more
difficult for debtors to pay off their debts. Therefore, consumers
and firms have to spend a bigger percentage of disposable income
on meeting debt repayments. (in a period of deflation, firms will
also be getting lower revenue, and consumers will likely to get
lower wages). Therefore, this leaves less money for spending and
investment. This is particularly a problem in a balance sheet
recession where firms and consumers are trying to reduce their
exposure to debt. Europe has a big burden of government debt;
deflation will make it more difficult to reduce debt to GDP ratios.
3. Increased real interest rates. Interest rates can’t fall below
zero. If there is deflation of 2%, this means we have a real interest
rate of + 2%. In other words, saving money gives a reasonable
return. Therefore, deflation can contribute to an unwanted
tightening of monetary policy. This is particularly a problem for
Eurozone countries which don’t have recourse to any other
monetary policies like quantitative easing. This is another factor
that can lead to lower growth and higher unemployment.
 4. Real wage unemployment. Labour markets often exhibit
‘sticky wages’. In particular, workers resist nominal wage cuts (no
one likes to see their wages actually cut, especially when you are
used to annual pay increases. Therefore, in periods of deflation,
real wages rise. This could cause real-wage
unemployment. Unemployment in Europe is a major problem –
and low inflation is one reason.
5. More difficult for relative prices and wages to adjust. If
the average prices or wages are increasing by 3%, it is easier for
some goods to rise by 0% and some to rise by 6%. With inflation
of 0%, it is harder to get this relative change in prices or wages.
6. Deflation can become entrenched and difficult to end.
The experience of Japan in the late 90s and 00s was that when
deflation became the new norm, it was very hard to change
inflation expectations and regain normal growth.

Deflation tends to cause more deflation (without injection/intervention)

 Falling prices – lower confidence – leads to lower spending –
falling prices
 Falling prices – leads to lower wages – leads to less spending and
lower costs
 Falling prices – changes inflation expectations – people delay
purchases until price falls.
Doesn’t deflation make us better off because
things are cheaper?
Remember deflation usually means falling wages (or at least stagnant wages).
It also means higher unemployment. People with debts, for example,
mortgages, credit cards are likely to feel the squeeze more. Prices may be
falling, but the amount of money you have to spend is also likely to be falling.

Deflation is only good if prices are falling and your disposable income is rising.

It is true that some people, especially net savers, may feel better off during a
period of deflation. But, the problem is the wider macro-economic
consequences of recession and unemployment.

Problems of low inflation

EU inflation falling to 0.4% in August 2014.

Deflation is quite rare, but increasingly common are periods of low-inflation

(or disinflation) – inflation below the government target of 2%. Even low
inflation can be a real economic problem – though on a smaller scale than
deflation. Problems of low inflation include:

 Increased real debt burden. If people expected an inflation

rate of around 3-4%, they might take out debts, assuming a future
inflation rate of 3-4% to help reduce the real value. However, if
inflation is at 0.5%, the real value of the debt will fall much more
slowly than expected. Governments will also struggle to reduce
debt to GDP ratios because with low inflation, tax revenues will
rise much more slowly than expected.
 Tight monetary policy. With inflation of 0.5% and ECB
interest rates of 0.5% – monetary policy is too tight harming the
economic recovery. This is particularly a problem for Europe
because they are reluctant to pursue quantitative easing.
 The difficulty of adjusting wages and prices. This is
particularly a problem for the Eurozone where a fixed exchange
rate means countries like Spain rely on a prolonged period of
falling prices to restore competitiveness.
Potential benefits of deflation

Despite the many serious costs of deflation. The ‘right kind of deflation’ could
be beneficial.
On the left, deflation is caused by falling demand. It leads to lower output.

On the right, deflation is caused by increased productivity – it enables lower

prices and higher output.

The right kind of deflation will cause:

1. Deflation from increased efficiency and lower costs of
production. The right kind of deflation involves lower prices
through increased productivity and better technology. A-Level
students should think of the Aggregate Supply curve shifting to
the right – which both lowers the price level and increases real
GDP.
2. Improved international competitiveness. If one country
has deflation, and others have inflation, then that country will
become more internationally competitive, leading to a rise in
exports. During Japan’s deflation, they saw strong exports –
which helped offset the fall in consumer spending (though it still
wasn’t enough). However, if there is a region-wide period of
deflation – e.g., Europe in 2014, then you are not getting this
competitive advantage.
Although deflation in the twentieth century is often associated with economic
recession. In the nineteenth century, deflation was compatible with economic
growth.