Low and stable rate of inflation

Inflation, disinflation and deflation

Inflation is defined as a sustained increase in the general price level. When we speak of the
‘general price level’ we refer to an average of prices of goods and services in the entire economy,
not to the price of any one particular good or service. ‘Sustained’ means that the general price level
must increase to a new level and not fall back again to its previous lower level. Further, an increase
in the general price level does not necessarily mean that prices of all goods and services are
increasing; prices of some goods and services may be constant or even falling, while others are
increasing. The presence of inflation indicates that prices of goods and services are increasing on
average.
Deflation is defined as a sustained decrease in the general price level. As in the case of inflation,
deflation refers to an average of prices; it is likely to be uneven, with some prices constant or even
increasing.
Inflation is far more common than deflation; in fact, since the 1930s (the period of the Great
Depression), most economies around the world have been experiencing a rising price level, or
inflation.
Students sometimes confuse the difference between changes in the price level and changes in the
rate of inflation. In our discussions of the AD-AS model, we have frequently seen increases in the
price level; these indicate inflation. A change in the rate of inflation, by contrast, refers to a change
in how fast the price level is rising. If the price level increases by 5% in one year and then increases
by 7% the next year, this represents an increase in the rate of inflation. If the price level increases
by 10% in one year and by 7% the next year, this represents a decrease in the rate of inflation, and
is called disinflation. Disinflation therefore occurs when inflation occurs at a lower rate.
You must also be careful not to confuse a fall in the rate of inflation, or disinflation, with a fall in
the price level, or deflation. A fall in the rate of inflation, such as from 10% to 7%, means that the
price level is increasing at a lower rate, hence is disinflation. A fall in the price level indicates that
deflation is occurring. Deflation can be thought of as negative inflation. For example, deflation of
−2% means that the price level is falling at the rate of 2%.

Measuring inflation and deflation

The consumer price index
Measures of inflation (and deflation) are obtained by use of price indices (indices is the plural of
index). A price index is a measure of average prices in one period relative to average prices in a
reference period called a base period. One of the most commonly used price indices to measure
inflation is the consumer price index (CPI).

The consumer price index (CPI) is a measure of the cost of living, or the cost of goods and services
purchased by the typical household in an economy. It is constructed by a statistical service in each
country, which creates a hypothetical ‘basket’ containing thousands of goods and services that are
consumed by the typical household in the course of a year. The value of this basket is calculated for
a particular year (called a base year); this is done by multiplying price times quantity for each good
and service in the basket, and adding up to obtain the total value of the basket. The value of the
same basket of goods and services is then calculated for subsequent years. The result is a series of
numbers that show the value of the same basket of goods and services for different years. The CPI
is then constructed to show how the value of the basket changes from year to year by comparing its
value with the base year.
Once the consumer price index is constructed, inflation and deflation can be expressed as a
percentage change of the index from one year to the other, which is simply a measure of the
percentage change in the value of the basket from one year to another. Since the value of the basket
changes from one period to another because of changes in the prices of the goods in the basket,
these percentage changes reflect changes in the average price level. A rising price index indicates
inflation; a falling price index indicates deflation. CPIs and rates of change in the price level are
also calculated on a monthly basis and a quarterly basis.

The consumer price index (CPI) is a measure of the cost of living for the typical household, and
compares the value of a basket of goods and services in one year with the value of the same basket
in a base year. Inflation (and deflation) are measured as a percentage change in the value of the
basket from one year to another. A positive percentage change indicates inflation. A negative
percentage change indicates deflation.

Constructing a weighted price index

We will construct a consumer price index (CPI) for a simple economy where consumers typically
consume three goods and services: burgers, movie tickets and haircuts, shown in column 1 of Table
10.1. Column 2 gives us the quantities of each that the typical household buys in a year; these are
the weights. Note that a weighted price index is a price index that ‘weights’ the various goods and
services according to their relative importance in consumer spending.7 To construct a CPI, we
follow these steps:
 Decide which of the years will be the base year; we choose 2017.

 Use the price of each good and service in the base year (2017), to calculate its base
year value (multiply quantity in column 2 by 2017 prices in column 3); these
values appear in column 4.
 Add up all values in column 4 to get the total value of the basket in the base year;
this is $756, appearing at the bottom of column 4.
 Use the price of each good and service in 2018 to calculate its 2018 value (multiply
the number of units in the basket (column 2) by 2018 prices (column 5)); then do the
same using 2019 prices (column 7); the resulting values appear in column 6 for 2018
and column 8 for 2019.
 Add up the values in column 6 to obtain the total value of the basket in 2018; this is
$798 appearing at the bottom of column 6; do the same to find the value of the basket
in 2019, which is $900, appearing at the bottom of column 8.

We now have all the information we need to construct our price index for 2017, 2018 and
2019. Note that:

price index for a specific year

= value of basket in a specific year value of same basket in base year ×100
Therefore, the price index numbers for 2017, 2018 and 2019 are:
price index for 2017= 756 756 ×100=1.00×100 = 100.0
price index for 2018= 798 756 ×100=1.055×100 = 105.0
price index for 2019= 900 756 ×100=1.190×100 = 119.0
Note that the price index for the base year is always equal to 100.
 3 4 5 7
6
2 Prices of Value of Prices Prices 8
1 basket basket of Value of
Quantity of Value of
Good goods goods basket basket
(number basket basket
and and and goods goods
of units) goods goods and
service services services and and
in basket and services
s in base in base service services
(weights) services in 2019
year year s in in 2018
(2017) (2017) 2018 in 2019

Burgers 37 $3 $111 $4 $148 $5 $185

Movi
e $1 $1
25 $15 $375 $350 $400
ticket 4 6
s

Haircut $2 $2
15 $18 $270 $300 $315
s 0 1

Total
value $756 $798 $900
of
basket
Table 10.1: Constructing a hypothetical price index

To construct a weighted price index, (i) find the value of the basket in current prices for each year;
(ii) divide the value of the basket for each year by the value of the basket in the base year and
multiply by 100. This will give you the price index number for each year.

In the real world, calculations of price indices are complicated as they involve collecting price data
on thousands of goods and services and carrying out all necessary computations. This is done by
specialised statistical services in every country.

Using a weighted price index (the CPI) to calculate the rate of inflation
A price index can be used to calculate the rate of inflation. Suppose we are given the following
price index (it is actually the one calculated above for HL). The third row also shows the value of
the basket for each of the years.

Year 2017 2018 2019

Consumer price 100.0 105.5 119.0

index

Value of basket $756 $798 $900

The rate of inflation is the percentage change in the price index. It is also given by the
percentage change in the value of the basket. (This follows from the fact that the price index is
calculated from the values of the basket.) The percentage change in a variable A is calculated
by the following:
% change in A= final value of A−initial value of A initial value of A ×100
To calculate the percentage change in the price level from 2017 to 2018, we have the percentage
change in price index from 2017 to 2018:
= 105.5−100.0 100.0 ×100=5.5%
In fact, we did not need to do this calculation: we can simply read the inflation rate from the price
index, since 105.5 − 100.0 = 5.5%.

When the price level is presented as a price index, the rate of inflation is equal to the index number
of any year minus the index number of the base year (which is always 100).

Therefore, it follows that the rate of inflation in the period 2017–2019 is 119.0 − 100.0 = 19.0%.
However, it is only possible to read off the rate of inflation from a price index in this simple way in
those cases involving a percentage change in the price level relative to the base year, whose price
index number is equal to 100. 8 In other cases, we must use the formula above to calculate the rate
of inflation.
For example, to find the rate of inflation in 2018–2019:
% change in price index in 2018–2019
= 119.0−105.0 105.0 ×100=12.8%

We could have found the same rates of inflation by calculating the percentage changes in the value
of the basket:
% change in value of the basket in 2017–2018
= 798−756 756 ×100=5.5%
% change in value of the basket in 2018–2019
= 900−798 798 ×100=12.8% . We can see that these two percentages are the same as those
calculated by use of the consumer price index.

Note that a price index with increasing values over time (such as the example above) indicates
inflation. Decreasing values over time indicate deflation. Also, note that the first year in a price
index need not be the base year. For example, suppose we have the following price index:

2000 2001 2002 2003 2004

97.5 100.0 107.3 109.7 107.8
The base year is 2001, for which the price index is 100. This price index indicates that
inflation has occurred in 2000–2001, 2001–2002, and 2002–2003, but deflation has
occurred in 2003–2004.

Calculating real income

We know how to calculate real GDP from nominal GDP using the GDP deflator. We can
now use the CPI to calculate real income (of consumers, pensioners, or other social
groups):
real income = nominal income CPI ×100
 Clearly, if nominal income increases by the same percentage as the price level (measured by
the CPI), real income remains unchanged. The CPI is, in fact, very useful for calculating
adjustments that must be made to nominal income (of wage-earners, pensioners, etc.) in
order for these groups to maintain a constant or increasing real income.
A word of caution
Since the CPI compares price levels based on goods and services in a specific basket, it
only makes sense to calculate inflation rates from a price index constructed by use of the
same basket. Further, it is not possible to make comparisons of price levels (i.e. calculate
rates of inflation) across years by use of price indices that have a different base year, even if
the basket of goods and services is the same.

Therefore, for comparisons of index numbers to be meaningful, the index numbers must be
calculated using the same base year, and for the same basket of goods and services.

Problems with the consumer price index (CPI)

 Different rates of inflation for different income earners. The rate of inflation
calculated by use of the CPI reflects the change in average prices of goods and services
included in the basket. However, different consumers have different consumption
patterns depending on their income levels, and these may differ from what is included
in the basket. This means they face different rates of inflation than what is calculated on
the basis of the CPI basket.
 Different rates of inflation depending on regional or cultural factors. Exactly the
same idea as above applies to consumer groups whose purchases differ from the typical
household’s consumption patterns, because of variations in tastes due to cultural and
regional factors.
 Changes in consumption patterns due to consumer substitutions when relative
prices change. Each good and service included in the basket is weighted (multiplied by
the number of units of the good or service purchased by the typical household over a
year). However, as some goods and services become cheaper or more expensive over
time, consumers make substitutions, buying more units of the cheaper goods and less of
the more expensive ones. This results in changing weights, but because the weights in
the basket are fixed, the changes in consumption patterns cannot be accounted for in the
CPI. Therefore, the CPI gives a misleading impression of the degree of inflation,
usually overstating it.
 Changes in consumption patterns due to increasing use of discount stores and
sales. In many countries, consumers increasingly make use of discount stores and sales,
thus buying some goods and services at lower prices than those used in CPI
calculations. This is another reason why the CPI tends to overstate inflation.
 Changes in consumption patterns due to introduction of new products. In this case,
too, a fixed basket of goods and services cannot account for new products introduced
into the market, as well as older products that become less popular or are withdrawn
(consider for example the replacement of DVDs by on-demand services such as
Netflix).
 Changes in product quality. The CPI cannot account for quality changes over time.
 International comparisons. The CPIs of different countries differ from each other with
respect to the types of goods and services included in the basket, the weights used and
methods of calculation. This limits the comparability of CPIs and inflation rates from
country to country. To address this problem, the European Union (EU) has devised a
 Harmonised Index of Consumer Prices (HICP). The HICP determines consistent and
compatible rules that must be followed by EU countries in order to calculate CPIs that
are consistent with each other.9
 Comparability over time. Virtually all countries around the world periodically revise
their CPI baskets and change the base year (usually about every ten years) to try to deal
with many of the problems noted above. In many countries the weights of goods and
services are changed as often as every year. This means that whereas price index
numbers are comparable over short periods of time, over longer periods comparability
is lessened because of cumulative changes in the basket of goods and services.
The core rate of inflation
There are certain goods, notably food and energy products (such as oil) that have highly volatile
prices (meaning they fluctuate widely over short periods of time). Reasons for price volatility
include wide swings in supply or demand, causing large and abrupt price changes. When such
goods are included in the CPI, they may give rise to misleading impressions regarding the rate of
inflation. To deal with this problem, economists measure a core rate of inflation, which usually is
done by constructing a CPI that does not include food and energy products with highly volatile
prices.
UNDERSTANDING 10.4
Causes of inflation
We will examine two causes of inflation: demand-pull inflation and cost-push inflation.

Demand-pull inflation
Demand-pull inflation is caused by increases in aggregate demand, in turn brought about by
changes in any of the determinants of aggregate demand. Assume the economy is initially at full
employment equilibrium, producing potential GDP, shown as Yp in Figure 10.5(a) and (b). The
economy experiences an increase in aggregate demand appearing as a rightward shift of the AD
curve from AD1 to AD2 in both diagrams. The impact on the economy is to increase the price level
from Pl1 to Pl2, and to increase the equilibrium level of real GDP from Yp to Yinfl. The increase in
the price level from Pl1 to Pl2 due to the increase in aggregate demand is known as demand-pull
inflation.

Figure 10.5: Demand-pull inflation

Note that demand-pull inflation is associated with an inflationary gap: real GDP is greater
than full employment GDP, and unemployment falls to a level below the natural rate of
unemployment. The demand for labour is so large that some workers who are structurally,
frictionally or seasonally unemployed temporarily find jobs.

Demand-pull inflation involves an excess of aggregate demand over aggregate supply at

the full employment level of output, and is caused by an increase in aggregate demand. It
is shown in the AD- AS model as a rightward shift in the AD curve.

Cost-push inflation
Cost-push inflation is caused by increases in costs of production or supply-side shocks. Assume the
economy is initially at the full employment level of output, Yp in Figure 10.6, and suppose there is
an increase in costs of production. The SRAS curve shifts from SRAS1 to SRAS2, leading to an
increase in the price level from Pl1 to Pl2, and a fall in the equilibrium level of real GDP from Yp to
Yrec. The increase in the price level due to the fall in SRAS is known as cost-push inflation.

Cost-push inflation is analysed only by means of the monetarist/new classical AD-AS model. The
Keynesian model is not equipped to deal with short-term fluctuations of aggregate supply. Keynes
was concerned with showing the importance of aggregate demand in causing short-term
fluctuations. The output level Yrec, though indicating a recession, is not called a
recessionary/deflationary gap, because output gaps (whether recessionary or inflationary) can only
be caused by too little or too much aggregate demand.

Figure 10.6: Cost-push inflation

We know that a decrease in SRAS poses a special set of problems because it leads to both inflation
and a fall in real GDP. The presence of both inflation and unemployment is called stagflation, a
combination of the words ‘stagnation’ and ‘inflation’. This should be contrasted with an increase in
aggregate demand leading to demand-pull inflation, which results in a higher price level but an
increase in real GDP (with less unemployment). Cost-push inflation, or stagflation, is more difficult
to deal with effectively.

Cost-push inflation is caused by a fall in aggregate supply, in turn resulting from increases in wages
or prices of other inputs, shown in the AD-AS model as leftward shifts of the AS curve.
Costs of a high rate of inflation
Inflation, and especially a high rate of inflation, poses problems for an economy, because it affects
particular population groups especially strongly, as well as the economy as a whole.

The relationship between inflation, purchasing power and nominal and real income
To understand why problems can arise, let’s consider the relationship between inflation and
purchasing power, and nominal and real income. Purchasing power refers to the quantity of goods
and services that can be bought with money. Imagine you have £60 to spend on shirts. You can
think of this as your ‘nominal income’. When the price is £20 per shirt, you can buy three shirts. If
the price increases to £30 per shirt, you can only buy two shirts. Your money, or your nominal
income of £60 has not changed, yet the purchasing power of the £60, or what this money can buy,
has fallen due to the increase in price. ‘Real income’ is the same as ‘purchasing power’; it refers to
what your money can buy: it decreases as prices rise, and increases as prices fall.

Changes in real income, money income and the general price level are related to each other in the
following way:
% change in real income (or purchasing power) = % change in nominal income − % change in the
price level (or the rate of inflation)

These relationships illustrate some important points. Inflation leads to a fall in real income, or
purchasing power, only if nominal income is constant, or if nominal income increases more slowly
than the price level. Say there is a 5% increase in the price level, which is a 5% rate of inflation.
How will your real income be affected? If your nominal income also increases by 5%, your real
income, or purchasing power, remains unchanged. Therefore, for you, inflation is not a problem. If,
however, your nominal income remains constant or increases by less than 5%, your real income
falls, and you will be worse off since the purchasing power of your income is reduced.

Costs of inflation
Redistribution effects
Inflation redistributes income away from certain groups in the economy and towards other groups.
Redistribution arises in situations where certain groups lose some purchasing power and become
worse off, while other groups gain purchasing power and become better off. Groups who lose from
inflation include:

People who receive fixed incomes or wages. When individuals receive an income or wage that is
fixed or constant, as the general price level increases they become worse off. This occurs when:
 workers have wage contracts fixing their wages over a period of time
 pensioners receive fixed pensions
 landlords receive fixed rental income
 individuals receive fixed welfare payments.
People who receive incomes or wages that increase less rapidly than the rate of inflation.
When individuals’ incomes do not keep up with a rising price level (do not increase as fast as the
price level), a fall in their real incomes results and they therefore become worse off. These groups
may include all those noted above plus any other kind of income receiver whose income is not
increasing as rapidly as the price level.
Holders of cash. As the price level increases, the real value or purchasing power of any cash held
falls.
Savers. People who save money may become worse off as a result of inflation. In order to maintain
the real value of their savings, savers must receive a rate of interest that is at least equal to the rate
of inflation. Suppose you deposit $1000 in a bank account that pays you no interest. If there is
inflation, the real value of your savings will fall. However, you may be able to protect the
purchasing power of your savings. Say the rate of inflation is 5% per year. If you receive interest on
your deposit at the rate of 5% per year, what you will lose through inflation will be exactly matched
by what you gain through interest income. In this case, the real value (or purchasing power) of your
savings remains unaffected. In general, savers who receive a rate of interest on their savings lower
than the rate of inflation suffer a fall in the real value (or purchasing power) of their savings.
Lenders (creditors). People (or financial institutions such as banks) who lend money may be worse
off due to inflation. Assume you lend your friend €100 for one year (and you do not charge
interest). If in the course of the year there is an increase in the price level (inflation), the real value
of the €100 you will get back from your friend at the end of the year will have fallen. If you charged
your friend a rate of interest equal to the rate of inflation, then the real value of your loan to your
friend will be exactly maintained. In general, lending at a lower interest rate than the rate of
inflation makes the lender (creditor) worse off at the end of the loan period.
Groups who gain from inflation include:
 Borrowers (debtors). In the example above, your friend who borrowed €100 from you
benefits since the €100 paid back after one year is worth less than one year ago. If you
had charged interest, your friend (the borrower) would benefit as long as the rate of
interest is lower than the rate of inflation. In general, borrowing at a lower interest rate
than the rate of inflation makes the borrower (debtor) better off at the end of the loan
period.
 Payers of fixed incomes or wages. As long as nominal wages, pensions, rents, welfare
payments, etc., are fixed while there is inflation, the payers (whether they are firms, the
government, payers of rent, etc.) benefit as the real value of their payments falls due to
inflation.
 Payers of incomes or wages that increase less rapidly than the rate of inflation. As
long as incomes of any kind increase less rapidly than the rate of inflation, the payers of
these incomes benefit due to the falling real value of their payments.

Uncertainty
Inability to accurately predict what inflation will be in the future means that people cannot predict
future changes in purchasing power (of income, wealth, loans and anything else that is measured in
terms of money). This causes uncertainty among economic decision-makers. Firms, in particular,
become more cautious about making future plans under uncertainty about future price levels,
because they are unable to make accurate forecasts of costs and revenues. Their uncertainty leads
them to make fewer investments, which may lead to lower economic growth.

Effects on saving
We saw above that when there is inflation, savers lose if they receive no interest on their savings or
if the rate of interest on their savings is lower than the rate of inflation. Therefore, inflation lowers
the incentive to save. Further, if the rate of inflation is high, people may spend more now in order to
avoid higher prices in the future, in which case the effect may be to further lower saving.

International (export) competitiveness

When the price level in a country increases more rapidly than the price level in other countries with
which it trades, its exports become more expensive to foreign buyers, while imports become
cheaper to domestic buyers. The country’s international competitiveness, or its ability to compete
with foreign countries, is reduced. The result is that the quantity of exports falls, and the quantity of
imports increases. This in turn may create difficulties for the country’s balance of payments.

Effects on economic growth

High inflation does not favour economic growth. As we have seen above, among the consequences
of inflation are uncertainty among firms, which causes investment to fall; in addition lower saving
means that there are less funds available for investment. These two factors lead to drops in
investment, which is a component of aggregate demand, therefore to a fall in aggregate demand.
Moreover, we have also seen that inflation leads to lower exports and higher imports, both
contributing to a fall in net exports, which also causes a fall in aggregate demand. Falling aggregate
demand leads to lower real GDP.

Effects on resource allocation

The price mechanism plays an important role in resource allocation. If prices are rising rapidly, the
signalling and incentive functions do not work effectively. The reason is that prices do not increase
in the same proportion for all products, they rise more for some products than for others, meaning
that the signals and incentives they provide for consumers and producers become distorted and
therefore inaccurate. The result is that allocative inefficiency is increased.

Social and personal costs that are unequally distributed

In view of the redistribution effects of inflation, we have seen that people on fixed incomes suffer
losses as their income loses its purchasing power. This often includes pensioners, unemployed
people receiving unemployment benefits, and also workers whose wages are either fixed or do not
rise as fast as the rate of inflation. In addition, people on low incomes are not in position to place
their savings in assets that do not lose their value with inflation, such as real estate, stocks in the
stock market, gold or even jewellery. Further, rising prices of necessities such as food and energy
needed for heating can cut deeply into the incomes of lower income people. Therefore it is likely
that people on low incomes are more seriously affected by high rates of inflation than people on
higher incomes.

Consequences of hyperinflation
Hyperinflation consists of very high rates of inflation. It is defined as occurring when the price level
increases by more than 50% per month, though it can reach thousands or even millions of
percentage points per year. One of the most dramatic hyperinflations in history occurred in
Germany after the First World War, when the price level in 1924 was more than 100 trillion times
higher than in 1914. In more recent years, many hyperinflations have been concentrated in Latin
America from the mid-1980s to the early 1990s, and in eastern European and former Soviet Union
countries in the early 1990s following the collapse of the Soviet Union. Peak annual rates of
inflation came to about 7500% in Peru in 1990; 3080% in Argentina in 1989; 2950% in Brazil in
1990; 1735% in Russia in 1992; 4735% in Ukraine in 1995; and 1060% in Bulgaria in 1997. One of
the most serious cases of hyperinflation occurred in Zimbabwe, where the rate of inflation went
from over 1000% in 2006, to 12 000% in 2007, and to over 11 million % (on an annual basis) in the
summer of 2008. In Venezuela in 2018 inflation was an estimated 80 000%.

Hyperinflation results from very significant increases in the supply of money, which impact directly
on the price level. Hyperinflations occur when governments resort to printing money, thereby
increasing its supply.

Hyperinflation has serious negative consequences, over and above those discussed above, because
money loses its value very rapidly. Consumers increase their spending to benefit from the current
prices before they increase in the future, thereby feeding aggregate demand, which causes demand-
pull inflation. Workers demand higher nominal wages to maintain the real value of their current and
future incomes, thereby feeding cost-push inflation. Therefore, an inflationary spiral is created (a
process where inflation sets in motion a series of events that worsen the inflation).

Serious hyperinflations result in a massive disruption of economic activity: businesses stop

investing in productive activities and invest instead in assets that are believed to maintain their
value as prices rise (gold, real estate or jewels); firms also withhold goods from sale in the market
so that they can sell them later at higher prices; lenders (creditors) suffer massive losses as the real
value of debts falls dramatically. At the extreme, money loses its value altogether and people resort
to barter (the direct exchange of goods or services, eliminating the need for money), which in itself
makes production and exchange extremely difficult. Serious hyperinflations can also lead to
political and social unrest.

What is an appropriate rate of inflation?

Most governments prefer a low and stable rate of inflation, not a zero rate of inflation. The reason
why a zero rate of inflation, meaning a constant price level, is not preferred is that this comes
dangerously close to deflation, which as we will see below can cause serious problems for an
economy.

There is no one particular rate of inflation that is ideal, but many governments would like to see this
in the range of about 2–3% per year. Less than 2% might be considered as coming close to
deflation; more than 4% is seen as being too high.

Causes of deflation

Why deflation occurs rarely in the real world

Deflation, a falling price level on average, is not a common phenomenon. Whereas it is often the
case that the price of a particular good or service may fall over time, it is rare to see the general
price level of an economy falling. There are several factors that account for this:
 Wages of workers do not ordinarily fall. This means it is difficult for firms to lower
the prices of their products, as this would cut into their profits, especially since wages
represent a large proportion of firms’ costs of production. There are several reasons why
wages do not fall easily (labour contracts, minimum wage legislation, worker and union
resistance to wage cuts, ideas of fairness, fears of negative impacts on workers’ morale,
etc.)
 Large oligopolistic firms may fear price wars. If one firm lowers its price, then
others may lower theirs more aggressively in an effort to capture market share, and then
all the firms will be worse off. Therefore, firms avoid cutting their prices.
Whereas deflation occurs rarely, it has appeared periodically, for example in Britain and the
United States in the late 19th century, in the United States during the Great Depression of the
1930s (1933– 1937), and in Japan from 1999 to 2006. In 2003 and again in 2008, there were
serious concerns in Europe and the United States that deflation might occur. Deflation is
generally feared more than inflation for reasons we will discover below.

Causes of deflation
We can make a distinction between two causes of deflation: decreases in aggregate demand and
increases in aggregate supply. These can be seen in Figure 10.8.

In Figure 10.8(a) a decrease in aggregate demand (for example, due to business pessimism) causes
the AD curve to shift from AD1 to AD2. Whereas the AD-AS model predicts a drop in the price level,
or deflation, this is unlikely to occur over a short period of time for the reasons discussed above,
accounting for the highly infrequent occurrence of deflation.10 However, if low aggregate demand
persists over a long period, the price level falls to Pl2. This is sometime referred to as ‘bad’
deflation because it is associated with recession, falling incomes and output since real GDP falls
from Y1 to Y2, and cyclical unemployment. These are the circumstances that characterised the
deflation of the Great Depression during the 1930s and, more recently, in Japan.

Figure 10.8(b) shows a rightward shift of the SRAS curve, with the AD curve constant, which gives
rise to a new point of equilibrium that occurs at a lower price level. This is sometimes referred to as
‘good’ deflation because it is associated with economic expansion since real GDP increases from Y1
to Y2, rising incomes and output, increasing employment and economic growth. Some economists
argue that it was under such circumstances that the deflation of Britain and the United States in the
late 19th century occurred.

However, it must be stressed that while it may be possible to make a theoretical distinction between
‘good’ and ‘bad’ deflation, no deflation is ever good. We will discover the reasons for this in the
following pages, where we will see that deflation discourages spending, causing aggregate demand
to fall regardless of the causes of deflation. Deflation is therefore considered by economists to be a
greater threat than inflation.

Figure 10.8: Causes of deflation

Costs of deflation

Redistribution effects
The redistribution effects of deflation are the opposite of those of inflation: with a falling price
level, individuals on fixed incomes, holders of cash, savers and lenders (creditors) all gain as the
real value of their income or holdings increases. By contrast, borrowers (debtors) and payers of
individuals with fixed incomes lose with a falling price level, as they must pay out sums that have
an increasing real value.
Increase in the real value of debt
In view of the above, the real value of debt increases. If you hold $1000 and the price level falls,
this means that the purchasing power of your money increases because you can buy more things
with that amount. In just the same way if you owe this $1000, its real value in terms of its
purchasing power increases when the price level falls.

Uncertainty
Deflation, like inflation, creates uncertainty for firms, which are unable to forecast their costs and
revenues due to declining price levels.

Deferred consumption, high and increasing cyclical unemployment: risk of a deflationary

spiral

Deferred consumption means that consumers postpone spending. Consumers postpone making
purchases when they see falling prices as they expect that prices will continue to fall. Therefore,
deflation discourages spending. Deflation also discourages borrowing by both consumers and firms,
because the real value of debt increases as the price level falls. The result is that consumer and
business spending falls, causing aggregate demand to fall. Falling AD results in lower real GDP
with cyclical unemployment, and also causes the price level to fall further. This in turn gives rise to
further postponement of spending, AD falls further, unemployment increases further, incomes and
prices fall further, deflationary pressures increase further, and so on in a downward spiral. This is
known as a deflationary spiral, shown in Figure 10.9.

Risk of bankruptcies and a financial crisis

As we saw above, deflation results in an increase in the real value of debt. If the economy is in
recession, and incomes are falling while the real value of debt is increasing, the result will most
likely be bankruptcies of firms and consumers who are unable to pay back their debts. If such
bankruptcies become widespread, banks and financial institutions will be affected, and a large risk
of a major financial crisis arises.

Figure 10.9: Deflationary spiral

Inefficient resource allocation

As we saw earlier, high rates of inflation lead to inefficient resource allocation because the
signalling and incentive functions of prices are unable to work effectively. In deflation, prices of all
goods and services do not fall uniformly, with the result that the price signals and incentives get
distorted, leading to resource misallocation.
Policy ineffectiveness
Once a deflation sets in, it may be difficult for policy makers to deal with it. One reason is that
when people’s expectations of a falling price level become well established, and they get used to
spending less in expectation of falling prices, it may be difficult for them to change their mindset.
Another very important reason is that expansionary monetary policy may become ineffective. This
monetary policy involves decreases in the rate of interest in order to encourage more borrowing and
spending by consumers and firms, however once interest rates approach zero they cannot continue
to fall. Therefore, monetary policy cannot be relied upon to solve the problem.

Summing up deflation
High cyclical unemployment, together with the risks of a deflationary spiral and a financial crisis,
reveal the special and potentially serious dangers of deflation. These are worsened by the
difficulties of finding solutions to the problem of deflation.

You can now see why governments prefer a low and stable rate of inflation, with a target rate of
around 2% per year, which is sufficiently above zero so as not to be too close to deflation.

In addition, you can see why the distinction between ‘good’ and ‘bad’ deflation is actually
meaningless, because once deflation sets in it does not matter how it originated since a deflationary
spiral may result even from ‘good’ deflation.

A positive effect of deflation

In spite of all the negatives of deflation, there is one positive effect worth mentioning. While
inflation hurts international competitiveness, deflation brings benefits. A lower price level means
that exports may increase as foreigners now prefer buying from the country with lower prices while
imports may fall as domestic consumers prefer the lower-price domestically produced goods.
Therefore net exports (X − M) increase, putting an upward pressure on aggregate demand and real
GDP. However, this positive effect is not enough to counteract all the risks and dangers of deflation.

7 In the real world, the weights used to construct the CPI are based on the proportion of consumer spending on each
good or service on average, rather than on the quantity of each good or service consumed.

8 Note that we can only use this rule for years after the base year and not before. For example, if the CPI is 92 in 2007 and
100 in 2008, we cannot say there is an 8% increase in the price level in the period 2007–2008. To convince yourself, do the
calculation. You will find that the rate of inflation is 8.7%.

9 The HICP does not determine a uniform basket for all countries (this is done in recognition of the point noted above that
different regions/countries have different consumption patterns due to diverse tastes, cultural factors and income levels).
The HICP succeeds to a large extent in resolving the comparability problem, and whereas it is not intended to replace
national CPIs, it is used in all cases where comparisons across countries need to be made. The HICP is calculated by all
European Union countries plus Iceland and Norway. The first base year to be used was 1996, and the index began being
calculated from January 1997.

Exploring the relationship between unemployment and inflation

The relative costs of unemployment versus inflation
During the 1970s, a well-known U.S. economist, Arthur Okun, created a ‘misery index’ which
consists of the sum of the unemployment rate and the inflation rate of a country. The higher the
index, the greater the misery of a population. However, the misery index does not distinguish
between the separate effects of unemployment and inflation on the well-being, or lack of well-
being, of a population. Can we say anything about which of the two contributes more to misery, or
has greater costs? From a purely economic perspective, it is difficult to generalise about which of
the two is less desirable, as this is likely to depend on the particular circumstances of the economy
being considered, as well as on how high is the unemployment versus how high is the inflation.
In addition to the economic costs, we have seen that both unemployment and inflation have
personal and social costs, over and above the economic ones. A number of studies that have
examined the effects of unemployment versus inflation on well-being conclude that, between the
two, unemployment has a stronger negative impact.

According to one such study that measured the loss of well-being, it was found that both
unemployment and inflation increase unhappiness. The study was based on a very large European
dataset for the period 1975–2013, which included periods of high inflation as well as periods of
high unemployment. It was found that unemployment increases unhappiness far more than
inflation. Specifically an increase of one percentage point in unemployment lowers well-being
nearly six times more than a one percentage point increase in inflation. Unemployment lowers the
happiness of not only the unemployed but also the people around them, with women and the elderly
being relatively more affected.

This is perhaps hardly surprising as the loss of a job leading to unemployment and therefore loss of
income has potentially very serious financial, personal and social effects on the unemployed
individuals and their families.

The conflict between low unemployment and low inflation

There are a number of potential conflicts between macroeconomic objectives. One of these conflicts
is between the objectives of low unemployment and low inflation. This can be understood by use of
the Keynesian AD-AS model, shown again in Figure 10.10. When there is a deflationary gap and the
economy is in recession such as at output level Y1 or Y2, the rate of inflation is low (the price level
is constant) but there is high cyclical unemployment. As aggregate demand increases and the
economy approaches potential output, Yp, the price level begins to rise while cyclical
unemployment falls. As aggregate demand continues to increase, the price level increases even
faster, while unemployment continues to fall. If aggregate demand increases further resulting in an
inflationary gap such as at Y4, unemployment falls to a level that is even lower than the natural rate,
since some of the structurally, seasonally and frictionally unemployed will now find employment.

The reason behind the increasing inflationary pressures is that as aggregate demand increases,
resources are used more fully, giving rise to bottlenecks that result in higher wages and other
resource prices. This process gives rise to higher product prices and hence a rising price level.
Figure 10.10: Keynesian model showing increasing price level with decreasing unemployment

It can therefore be concluded that it may be difficult to achieve both a low rate of inflation and a
low unemployment rate at the same time.

THEORY OF KNOWLEDGE 10.2

INQUIRY AND REFLECTION