Deflation Is in General Understanding Is Fall in Price

Deflation is in general understanding is fall in price. There is a significant fall in price of goods and services resulting in decrease in aggregate demand. Deflation means a downward movement in economy due to reasons like a reduced cost of production or increase in living standard of people. Deflation occurs when there is negative inflation or the given rate falls below zero percent and the real value of money increases.

Deflation is caused by two factors (Econmics journal, 2018)-

1. A fall in aggregate demand (AD) - An example can be taken when the government reduces the spending.

2. A shift to the right of aggregate supply (AS) – i.e. lower costs of production through improved technology.

We can take UK as an example who experienced deflation. One important factor was that the government tried to maintain the value of Pound Sterling against the dollar at close to $4.85. The above figure shows how deflation actually looks like (Office for National Statistics , https://www.ons.gov.uk/).

Deflation can have its positive side. There is improvement in production efficiency as the overall price, raw material cost decreases. The production efficiency of a country develops. The consumer pay less while buying goods and services. The overall purchasing power increases of the consumers.

There is an increase in real value of debt when there is a condition of deflation. There is also an increase in borrowing or the overall cost of borrowing increases due to inflation. Real interest rates will rise if nominal rates of interest do not fall in line with prices. There is also a risk of lower profit margin resulting from reduced revenues. This will directly have an impact and increase the overall unemployment rate (Fama, 1990).

Deflation negatively impacts the borrowers and liquid asset holders directly. The savers are benefited from this condition. Here, the risk-adjusted return of assets becomes negative in nature, thereby encouraging the purchasers and investors to gather money, rather than investing it in solid and assured securities. There is liquidity trap where the nominal interest closes on to zero.

Deflation does not promote investment or expenditure on product. There is fall in overall aggregate demand. In this case,