Deflation

Deflation is decreasing in the general price level.

Deflation might be caused by decreasing in the

aggregate demand (as we know aggregate demand=

consumption+government spanding+investment+

exports - imports).

From the diagram above we can see that AD decreases

and shifts to the left and price decreases from P to P1.

Possible Economic Costs of Deflation:
-Holding back on spending: Consumers may prefer to spend

money later if they expect prices to fall further in the future.
-Debts increase: People might spend less because

the real value of household, corporate and government debt

rises when the price level is falling.
-The real cost of borrowing increases: Real interest rates will

rise if nominal rates of interest do not fall in line with prices –

another factor driving spending lower.
-Lower profit margins: Company profit margins come under

pressure unless costs fall further than final prices to consumers –

this can lead to higher unemployment as firms seek to reduce

their costs. Weaker profit margins can also have a negative effect

on stock markets because of a fall in expected profits and dividends

to shareholders
-Confidence and saving: Falling asset prices such as price deflation

in the housing market hit personal sector financial wealth and confidence –

leading to further declines in AD and a rise in precautionary savings

(the average and marginal propensity to save will tend to rise).

However deflation can also be caused by an increase

in a nation's productive potential which leads to an

excess of aggregate supply over demand.

From the second diagram above we can see that long run

aggregate supply increases and shifts to the right and price

falls from P1 to P2. This increasing of LRAS might be

caused by technological improvement or increasing in

a nation's productive potential.

In this case deflation might cause an increasing in the

country's economic growth. Consumers gets the benefit

of technology and increased competition in the form of

lower prices leading to an improvement in economic welfare.