What is the consequence of deflation in terms of aggregate demand?

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What is the consequence of deflation in terms of aggregate demand?


Deflation refers to a situation when prices fall. Deflation has adverse effects in terms of aggregate demand. Some of the economic consequences of deflation include;

  1. Consumption Delay: Deflation can make consumers delay consumption with hopes of further fall of prices. The scenario can create an adverse effect on incomes, output, and aggregate demand.
  2. High rates of interest: Since nominal interest never falls below zero, this implies that deflation causes a rise of interest rates. For instance, if inflation is at 1 percent and nominal interest rates at 5 %, actual interest rates are at 4 percent, calculated as 5%-1%. Nevertheless, when price fall lets say by 2 percent, real interest rates becomes 7 percent, calculated as 5%-(-2%). Even though nominal interest rates may reduce but deflation inserts pressure for real rates to rise.
  3. Bankruptcy: Deflation creates huge burdens particularly for households that have loans or borrowed in the past. Firms and consumers have debt burden including loans and mortgages, and when prices do not fall, the real price rises creating more bankruptcy. Again companies experience debt burden as repayment of debt remains steady rising actual cost and debt burden.
  4. Recession: Since confidence in the economy begins to fall companies and households start saving than spending. A long period recession is dubbed as Japanese disease since Japan embroiled in spiral deflation in the 1990s.

However, deflation can be viewed as positive since falling of prices is an automatic response to money contraction and this condition ensures less spending due to less money. Consequently, there is reduced hiring of workers and purchasing of goods. In other words, there is low demand.



Scott, W. (1982). Fundamentals of managerial economics. Managerial And Decision Economics, 3(1), 52-53. doi: 10.1002/mde.4090030112