Deflation

Defined as a sustained fall in the general level of prices, deflation can be the result of a sudden decline in economic activity.

Deflation tends to make consumers reduce their purchases in the expectation of being able to buy more cheaply at a later date. That can have a depressing effect upon demand and lead to a reduction of output. Another potentially important effect is to require borrowers to repay more than they had borrowed (for example, if prices declined by 20 percent, a farmer who had previously borrowed £100 to buy ten pigs would have to repay the equivalent of twelve pigs). The resulting loss to borrowers may be balanced by gains to lenders, but if borrowers are forced to default, the resulting disruption can lead to a further reduction in output. Another effect is to require employers to pay their employees the same wages despite a reduction in income from their employees' output. Unless there is a compensating wage reduction, that may result in a reduction in employment and another reduction in output.

Given time, adjustments could be made to limit the resulting output losses, but the output losses from a sudden and unexpected deflation could feed upon themselves by reinforcing the tendencies that produced them. For example the output loss from the deferrment of purchases could lead to an increase in unemployment which could prompt a further reduction in spending and thus a further increase in unemployment.

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