Why is deflation a cause of concern?

04 Nov Why is deflation a cause of concern?

Deflation is the sustained fall in general price level. Government will be more concerned with deflation if the deflation is caused by a fall in aggregate demand during economic recessions.

For Singapore, a worldwide recession is likely to cause a fall in exports and hence a fall in in aggregate demand. This will result in a leftward shift in the AD causing the general price level to fall and also a fall in the real GDP. As demand for goods and services fall, firms will cut back on their production and this will lead to a fall in the demand for labour. Producers will start to retrench workers and this will lead to a rise in cyclical unemployment. To the producers, lower prices also cause uncertainties to the firms and firms will start hold back on investment resulting in a further fall in aggregate demand and higher unemployment.

Consumers, on the other, will benefit from the lower prices in the short run. Lower prices will allow consumers to buy more goods and services. There will be redistribution of income caused by a fall in general price level. To the saver, their savings will also increase in real value. This will increase their material standard of living. Fixed income earners will now enjoy higher real income and hence higher purchasing power to consume.

Borrowers, on the other hand, will lose out as they have to repay their loans that have an increasing real value. However, in the long run, if prices continue to fall, consumers will hold back their consumption in anticipation of further fall in prices. This will result in firms cutting back on production and hence a fall in AD which results in higher unemployment. With lower or no income, consumers will cut back on consumption and this will result in a deflationary spiral which worsens the country’s economic growth and rising unemployment, thus penalizing consumers.

To the government, lower prices creates uncertainties and will affect consumers and investors’ confidence hence affecting the government’s ability to achieve macroeconomic objectives such as sustained economic growth and low unemployment. Foreign firms are less willing to invest in the country given the bleak outlook and this will affect the country’s capital account and balance of payments. Government also collects less tax revenue with falling incomes and profits and spend more on unemployment or welfare benefits which may end up worsening the budget balance. Lower tax revenue will also mean less expenditure on merit and public goods which will affect the citizens’ standard of living.

In conclusion, it is important for the government to identify the cause of deflation and assess the impact on the economy and finally implement appropriate policies to manage the economy when faced with deflation.