If the price level falls, an economy experiences price deflation. Rising prices create a number of economic problems. Because changes in the price level cannot be measured precisely, increases of less that 1% a year are considered to be deflationary, and also warrant intervention. Deflation can cause the following economic problems:
Given that nominal interest rates cannot fall below zero, falling prices cause real rates to rise. For example, if nominal interest rates are currently 5% and inflation is 1%, real interest rates are 4% (which is 5% – 1% = 4%). However, if the price level falls by 2%, real interest rates (5% – [-2%]) rise to 7%. Of course, nominal rates can be reduced, but deflation tends to put upward pressure on real rates.
Deflation will cause debt burdens to rise for households that have borrowed in the past. Many consumer and corporate debts are fixed, including fixed mortgages and personal loans, and repayments do not fall as prices fall, making the real price of the debt rise. For firms, falling prices also create a debt burden because, although revenues fall, debt repayments may remain at the old level, increasing the real debt burden.
This is because economic confidence begins to fall as households and firms save rather than spend. Long term recession following deflation is often called the Japanese disease, given that, for a long period during the 1990s, Japan seemed trapped in a deflationary spiral.
Following a positive supply shock, AS to AS1, prices fall from P to P1. Consumers may expect prices to fall further, and delay their consumption. This causes AD to shift to the left, from AD to AD1. Firms now cut prices further to boost sales and reduce stocks.
Deflation can be triggered by an increase in supply. As business and consumer confidence in the economy declines, AD falls, resulting in recession.
As confidence falls, and wages begin to fall, consumption falls further. Real interest rates rise, and savings rise.
Investment falls due to a negative accelerator effect triggering further price reductions as firms must compete with each other to attract increasingly scarce consumers. This creates a downward deflationary spiral, which is extremely hard to get out of.