Causes & Consequences of Deflation | Economics for GCSE/IGCSE - Year 11 PDF Download

Demand-side Deflation

• Deflation occurs when the average price level of goods/services in an economy decreases, as measured by the consumer price index (CPI).
  • Deflation is characterized by a percentage change in prices that falls below zero %.
• Deflation can be triggered by factors related to either the demand side or the supply side of the economy.
  • The causes of deflation, whether demand-side or supply-side, have distinct impacts on the economy.

Demand-side Deflation (Bad Deflation)

• Demand-side deflation arises from a decline in total (aggregate) demand within the economy.
• Total (aggregate) demand is the culmination of all expenditures in the economy, quantified by real Gross Domestic Product (rGDP).
  • rGDP = Consumption (C) + Investment (I) + Government spending (G) + Net Exports (X-M)
• A reduction in any of the four components of rGDP could result in a potential decrease in total demand within the economy, potentially leading to a decline in the general price level.
• This situation indicates the occurrence of demand-side deflation.

The Consequences of Demand-side Deflation

Supply-side Deflation

Supply-side deflation stems from enhancements in the economy's productive capacity.

• This enhancement occurs through increases in the quantity or quality of factors of production.
• Consequently, it leads to a surplus supply scenario within the economy.
• As a result, general price levels decline, while national output (rGDP) experiences an increase.

The Consequences of Supply-side Deflation