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Economics explained


Inflation and deflation

Bad deflation

Bad deflation

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Bad deflation takes place when the price level is driven down by a fall in aggregate demand as shown in the figure below

If people expect falling prices, they may delay purchases since their money will buy more later. Workers initially resist pay cuts, so employers must lay some off to cope with falling prices.

Eventually, fear of unemployment persuades workers to accept lower pay. Prices and wages follow each other down, the mirror image of an inflationary wage-price spiral.

Deflation is also associated with an increase in interest rates, which will cause an increase in the real value of debt. As a result, consumers are likely to defer their spending.

The aggregate demand curve shifts from AD to AD1 pushing down from P to P1. Real GDP falls from Y to Y1.

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