Falling prices can reflect weak demand or improved productive efficiency.
General prices can fall because aggregate demand weakens or aggregate supply improves. Demand-led deflation can accompany falling output, employment and incomes. Expected further price falls may encourage postponement of some durable purchases, reinforcing weak demand; necessities cannot all be postponed. Fixed nominal debts become harder to service relative to falling nominal revenues or incomes, and wages may not adjust easily. By contrast, productivity-driven price declines can coexist with greater real output and purchasing power. The cause, persistence, expectations and balance sheets determine the consequences; lower prices are not always either wholly good or wholly bad.
- Demand-led
- Weak AD can reduce output, employment, incomes and prices together.
- Supply-led
- Better productivity can lower prices while raising output.
- Debt effect
- A fixed cash repayment does not fall when prices fall. If the borrower's money earnings also fall, the payment takes a larger share of income and may become harder to afford.
Why the cause changes the consequences
Spending delay
People expecting lower prices may wait before replacing a car or appliance. Fewer purchases reduce firms' sales and can lead to lower output and incomes, weakening demand further. Food and other immediate needs cannot all be delayed.
Judgement
Identify the cause, persistence, expectations and distribution of effects before assessing welfare.
Worked example: Falling prices from two different causes
In economy A, general prices fall while broad sales and employment decline. In economy B, productivity improves, unit costs fall and firms sell more output at lower prices. Assume the stated supply improvement is the dominant change in B.
- A is consistent with weak AD shifting left and lowering both output and prices. Lost jobs and incomes may outweigh the benefit of cheaper products for many households.
- B is consistent with AS shifting down/right, giving more real output and a lower price level under unchanged AD.
- In A, delayed discretionary purchases and a heavier burden of fixed debts can deepen the weakness, but their strength depends on expectations and contracts.
- Do not infer the same welfare result from the shared fact of falling prices; identify the underlying mechanism and affected groups.
Watch out for this
All deflation proves the economy is in a demand-driven collapse.
A favourable supply shift can also lower the general price level while increasing output. Diagnose the cause.
Check your understanding
Productivity rises, unit costs fall and output increases while the general price level falls. Which explanation best fits?
- An adverse supply shock that cuts capacity.
- A favourable AS shift.
- Proof that households must all have lost jobs.