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Question

Explain how the rate of deflation is measured and the impact of a period of deflation on an economy.

Category:

Macroeconomic Factors and Policies

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Answer


Step ➊ : Define ‘deflation’ in the introduction.


Deflation refers to a sustained fall in the price level. Deflation involves a negative inflation rate, for example, –3%. In this essay, we will explain how the rate of deflation is measured and the impact of a period of deflation on an economy.


Step ➋ : Explain how deflation can be measured.


Deflation can be measured using the consumer price index. Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them.

Changes in the CPI are used to assess price changes associated with the cost of living; the CPI is one of the most frequently used statistics for identifying periods of inflation or deflation, if the CPI figure is negative, this implies a deflation.


Step ➌ : Explain the impact of a period of deflation on the economy.


The impact of deflation on an economy can be positive or negative.

➤ 3.1 Good deflation occurs as a result of an increase in aggregate supply and will have a positive impact on the economy.

The figure below shows that an increase in aggregate supply results in a fall in the price level and a rise in real GDP. Advances in technology, for instance, may create new methods of production and lower costs of production. As well as output increasing, employment may rise and the international competitiveness of the country’s products may increase.

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➤ 3.2 In contrast, bad deflation takes place when the price level is driven down by a fall in aggregate demand as shown in the figure below

In this case, output falls, which may result in higher unemployment. This runs the risk of developing into a deflationary spiral. Consumers may delay their purchases, expecting prices to fall further in the future.
Firms, seeing lower demand, may not invest and may reduce the number of workers they employ. These measures will reduce demand further and economic activity will decline again. 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.

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Step ➍ : Conclude.


To conclude deflation can be measured using the consumer price index. The impact of deflation on an economy depends as from whether it is caused by a rise in aggregate supply or a fall in aggregate demand.

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♕ Mark Scheme
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For knowledge and understanding of what is meant by deflation i.e. a fall in the general price level (1 mark) and how it is measured i.e. a fall in the Consumer Price Index (CPI). (1 mark) Allow reference to other methods of measuring changes in the price level such as the GDP implicit deflator. (KU: Up to 2 marks)

For application explaining the impact of deflation on an economy.

For each impact explained (Up to 3 marks)

So a minimum of two impacts explained is necessary for all the available marks here. Please note however that some answers might contain a number of impacts within one developed explanation.
There is no maximum in terms of the number of impacts explained, but it is essential that there is explanation of each rather than an unexplained list (1 mark maximum).

(APP: up to 6 marks)

The term deflation is used to describe a period in which there is a fall in the general price level. It is the opposite of inflation. It is usually measured through falls in the CPI. There are a number of effects. For example, the value of savings increases. Consumers usually put off purchases hoping that prices will be lower in the future. This means that firms usually lower wages to preserve profits, but often they have to reduce production and this often causes unemployment. Investment also often declines. Although deflation is likely to lead to a fall in the terms of trade it may well result in an increase in revenues from exports. Also, the relative price of imports rises and this may result in lower import expenditures.

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♕ Examiner’s report
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Most candidates who attempted this question showed a good idea of the meaning of deflation and how it is measured. There was also good knowledge and understanding of the impact of deflation on an economy with a wide range of effects considered. Some candidates distinguished between a ‘bad’ and a ‘good’ deflation and explained why these terms might be used. Those who missed out on marks often did so because their explanation of the impact was superficial and lacked depth and development.

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Step ➊ : Define ‘deflation’ in the introduction.


Deflation refers to a sustained fall in the price level. Deflation involves a negative inflation rate, for example, –3%. In this essay, we will explain how the rate of deflation is measured and the impact of a period of deflation on an economy.


Step ➋ : Explain how deflation can be measured.


Deflation can be measured using the consumer price index. Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them.

Changes in the CPI are used to assess price changes associated with the cost of living; the CPI is one of the most frequently used statistics for identifying periods of inflation or deflation, if the CPI figure is negative, this implies a deflation.


Step ➌ : Explain the impact of a period of deflation on the economy.

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