Deflation

Deflation is defined as the reduction in the general price level of an economy. 

Problems resulting from deflation;

• Consumers might delay consumption. This is because consumers will try to save their money until prices drop even further so they can purchase their desired good more cheaply. This will have a negative impact on aggregate demand, incomes and output

• Recession can occur due to reductions in consumer and business confidence. Consumers and businesses will rather save than spend. A recession caused by deflation is difficult to solve, since there will be a deflationary spiral in the economy.

• Increase in real interest rates, since nominal interest rates cannot fall below 0. If nominal interest rates are 5% and inflation is 1%, real interst rates are at 4%. However, if prices fall by 2% real interest rates rise to 7% (5% -(-2%) = 7%)

• A rise in debt burdens and deterrent to borrowing. Deflation will lead to an increase in debt burdens for households. Many debts are fixed such as mortgages. This means repayments dont decrease as prices fall leading to higher prices of the debt

Causes of deflation:

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• As seen on the diagram, a sudden increase in supply shifts the Aggregate Supply (AS) curve to AS1. The increase in supply leads to a lower price from P to P1 causing deflation as firms cut their prices to increase sales.
• Prices go further down as consumers delay spending thinking that the prices will go further down and firms decrease investments an they have less confidence in the economy. 
• Firms decreasing production leads to them lowering the wage rates. This decreases the consumption even further, lowering the AD curve even more.
• Less demand from consumers mean that firms lower prices to compete with each other to increase sales. This creates a downward deflationary spiral which is extremely hard to get out of.