Causes of deflation

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. Monetarists place emphasis on the role of the money supply – falling money supply and / or 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 inflation’ as output increases.

Falling Aggregate demand

https://www.economicshelp.org/images/macro/fall-AD.jpg

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

However, in practise, a fall in aggregate demand may not be sufficient to cause actual deflation. Instead, we may see just a fall in the rate of inflation (sometimes known as disinflation)

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.

Deflation caused by falling aggregate demand can be caused by more specific factors:

  1. Fall in the money supply. A fall in money supply and  / or a fall in the velocity of circulation
  2. Tight monetary policy – higher interest rates
  3. Debt deleveraging. After a credit bubble, people may be seeking to pay off debts and have to reduce their spending.
  4. Overvalued exchange rate and high interest rates to maintain value of currency.

Explaining periods of deflation

Deflation of 1920s

1914-38-inflationUK

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

real interest rates

  • Relatively tight monetary policy. Interest rates were kept high to keep 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. 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 great depression.

Deflation during the great recession

cpi-rpi-since2007

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 Eurzone, such as Greece and (to a lesser extent Spain) have experienced deflation.

aagreece

Source: (link)

This is because

  • They are seeking to regain competitiveness in the Single Currency, through internal devaluation (cutting prices and costs)
  • Bank lending has fallen significantly, with high bank rates. This has contributed to fall in money supply.
  • But, again the inflation in Spain, despite unemployment of over 26%, shows there is no clear link between spare capacity and inflation.

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3 thoughts on “Causes of deflation

  1. At the beginning of your Explanation, you use the term “AS”, but do not say what words those letters refer to. Please tell me.

    Other than that, your Explanation is cogent.

    Thanks!

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