Q68+-+Macro+Short+Answers

68. What are the likely consequences of deflation for a country’s economy? [M05, 3]
Deflation is a persistent fall in the average level of prices in an economy. Although the prospect of falling price levels might seem attractive to a consumer, there are many consequences of deflation which could have an adverse effect on a country's economy.

The most apparent effect of deflation will be the difficulty in determining the true value of products. Deflation and inflation affect the natural equilibrium and balance of an economy, and thus it will be difficult to determine the true value of a product.

However, the biggest issue that could arise due to deflation is unemployment. Deflation will decrease aggregate demand, and this will most likely result in businesses laying off workers to maintain profits. Thus, a deflationary spiral could ensue.

Furthermore, consumer expectations as a determinant of demand will result in deferred consumption and will affect aggregate demand immediately, as consumers will hold off purchasing goods in view of possibly lower prices in the future. As illustrated in the graph above, this deferred consumption will result in demand for labour in the economy reducing (Demand 1 - Demand 2). Thus the number of workers in the economy will decrease (Q2 - Q1) and wage rates will fall as illustrated. Such disequilibrium unemployment associated with cyclical downturns in the economy is known as demand-deficient or cyclical unemployment. Additionally, the decreased aggregate demand will result in households becoming pessimistic about the future economy, and will result in falling consumer confidence. This will further depress aggregate demand and a deflationary spiral may continue in such a fashion.

Deflation will also have an effect on investment. Due to deflation, businesses will make less profit, and will thus lay off workers. Business confidence will decline, further reducing chances of investment. Such reduced investment will have negative consequences on economic growth, and will further fuel falling prices and deflation.

Also, deflation could have significant costs to debtors and loan takers. Homeowners who might have taken a mortgage to fund their home purchase, might find themselves in an undesirable situation where the value of debt will rise as a result of deflation. If profits remain low for businesses, they might be unable to pay back these loans and could file for bankruptcy. Thus, business confidence ad the economy will be further worsened.

Hence, deflation has numerous negative consequences for an economy, which each government will attempt to avoid via inflationary monetary and fiscal policies.