Readers Question: State intervention is necessary to maximize social welfare but intervention often comes at a heavy price. So why not rely on the market system to tackle the problem? It is one of the great debates of economics – How much should the government intervene in the economy. Firstly we have to consider occasions …
If you speak to someone of the older generation, it is not long before they will start saying something like: “When I was a lad, you could get a pint of beer for only 10p, its outrageous how much it costs these days” Economies are more likely to experience inflation than deflation. Despite fall in …
GDP per capita would probably be the first measure to look at. It is the most obvious reflection of national income per person.
GDP per hours worked is also useful for determining the productivity of an economy. Though it depends what determines the number of hours worked – For example, is a low number of hours (and high GDP per hours worked) due to unemployment or greater efficiency leaving more time for leisure?
GDP / working hour could be inflated if there is a rapid drop in employment and hours worked. For example, if unemployment increased by 1 million because firms became much more strict in getting rid of surplus labour (causing structural unemployment), this would cause an increase in labour productivity and higher GDP per working hour. But, the rise in unemployment is a clear drop in living standards.
Readers Question: It has been suggested in a philosophy/economics class that I am taking that given the current state of income inequality between the 1% and 99%, that a period of stagflation might be an effective equalizer. I don’t see it. Any thoughts? Stagflation is a period of negative economic growth (or very low growth) …
Readers Question: Evaluate the possible consequences of a falling rate of inflation for the performance of the UK economy. A falling rate of inflation means that prices will be rising at a slower rate. A fall in the inflation rate could cause various benefits for the economy: Goods of that country becoming more internationally competitive …
Poverty implies low income and struggling to meet basic needs. There are two main types of poverty Absolute poverty – income below a certain threshold necessary to meet basic necessities of life (food, shelter, clothing, rent) Relative poverty – Individuals receiving income a certain level (e.g. 50%) below the median income of the general population. …
Readers Question: Can you please discuss the nature of the current account deficit and the exchange rate in the UK along with the theory that would suggest there is a relationship between the exchange rate and the current account. A current account deficit implies the value of imports of (goods/services/investment incomes) is greater than the …
Is deflation good or bad? Mostly experiences of deflation in western economies have been damaging – deflation has been associated with falling rates of economic growth and higher unemployment. However, it is possible to have a different type of deflation – from rapidly improving productivity; then deflation can be consistent with higher rates of economic growth.
The key issue is – what is causing the deflation and if prices are falling – what is happening to real wages and real interest rates?
Deflation caused by lower costs ‘good deflation’
If we have ‘good’ deflation – due to a big increase in productivity, lower costs – then in theory firms will be able to pay real wage increases. With this type of deflation, we are seeing lower prices, but also higher output, higher productivity, higher profits – and hopefully higher real wages. If consumers see lower prices, but they have rising real incomes, then you would expect higher spending because they will have the money to buy these cheaper goods.
A fall in costs of production lead to lower prices for consumers – but output increases
Example of good deflation 1870-1890
Towards the end of the nineteenth century, the US, UK economies benefitted from a worldwide fall in prices due to the “Second Industrial Revolution”. This included major improvements in productivity:
More efficient steam engines
Improved steel production (Bessemer Steel)
Cheaper cost of railways – railways came of age.
Improved communication.
The transition from agricultural to industrial production.
The US economy grew rapidly in this period – benefitting from the new technology which helped lower costs. An important feature of this period was that although prices fell, wages were constant or rose and so workers saw real wage growth.
Deflation caused by falling demand
Deflation caused by a fall in AD.
If we have ‘bad’ deflation – falling prices caused by weak demand, then firms will be seeing a decline in profitability. In this circumstance, firms will not be increasing wages but trying to cut wages. Also, if firms can’t cut nominal wages, we may see a rise in unemployment (a combination of real wage unemployment and demand deficient unemployment).
Therefore, in this scenario of lower wages / higher unemployment, the falling prices will not be sufficient to encourage spending and higher consumption. Instead, people will be risk-averse trying to save and waiting for prices to fall further.
Costs of deflation
If prices are falling but nominal wages are also falling or stagnant, we tend to get these problems.
Consumers delay purchases. With falling prices, consumers expect prices to be lower in the future, so put off purchasing goods.
Rise in real value of debt. With falling prices and falling wages, it becomes harder to pay off debt and meet debt repayments.
Real wage unemployment. With falling, prices firms can’t afford workers, but if workers resist nominal wage cuts, then there will be real wage unemployment
Higher real interest rates. Interest rates cannot fall below zero, so if there is deflation, the effective real interest rate rises. Therefore, even if the economy is depressed, real interest rates are high – discouraging borrowing and encouraging saving.
Deflationary cycle. In a deflationary cycle, lower demand leads to lower prices, and falling prices cause lower demand, it is a vicious circle.
Example of ‘bad’ deflation – the UK in the 1920s and early 1930s
Ignoring cost-push factors underlying inflationary pressures in the UK have been low – with inflation falling to zero in 2015. However, a significant reason for this deflation/low inflation is the poor productivity – and consequent stagnant real wages. Inflation is low, but households are becoming worse off.
Falling prices led to stagnant real GDP
Readers Question: And regardless of the reason, people should put off buying shouldn’t they?
It can depend on consumer confidence and expectations of future wages/employment opportunities. If we have a period of deflationary pressures – low /negative growth, then people may be fearful about future employment opportunities, they will expect low wage growth, and possibly unemployment – therefore, in this circumstances, consumers will be trying hard to be careful in budgeting and spending. If they think prices will fall and their income may decline, then this is an added reason to delay spending.
However, if there is strong growth, low unemployment and rising wages, there is much less need to be careful with spending – therefore, they will be willing to buy now and enjoy their rising real wages.
