‭ ) ‘While both inflation and deflation are undesirable, deflation poses greater risks for‬

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‭an economy compared to inflation.’‬‭Discuss‬‭this statement‬‭using real life examples to support‬
‭[15 marks]‬

I‭nflation is the sustained increase in average price level over time. This is caused by an‬
‭increase in Aggregate Demand. This increase is due to an increase in one or more of the‬
‭Aggregate Demand components including consumption spending, investment spending,‬
‭government spending, and spending on exports minus imports (C + G + I + (X - M)). For‬
‭example an increase in consumer confidence can lead to an increase in consumer spending as‬
‭consumers are more willing to spend as they trust that the economy is sustainable. This‬
‭increase in consumer spending causes AD to increase from AD to AD1 as there is a greater‬
‭total demand for goods and services in the economy. When AD increases, the real GDP also‬
‭increases from Yfe to Y1 as Real GDP can be measured through the same expenditure‬
‭approach as aggregate demand (therefore when consumer spending increases so does the‬
‭level of economic activity). At this point the actual level of output (AD=SRAS) is greater than the‬
‭potential output (Yinf>Yfe) and the rate of unemployment is less than the natural rate of‬
‭unemployment. This is because the increase in the level of output means that firms require‬
‭more labor in order to continue producing at such a level thus demand for labor increases and‬
‭unemployment decreases.‬

‭ he classical perspective assumes that in the long-run the economy will correct itself as prices‬
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‭and wages are flexible. Therefore, when the average price levels in the economy increase from‬
‭PL1 to PL2 because of the increase in aggregate demand, workers demand for higher wages.‬
‭This is because when price levels in the economy increase their purchasing power will decrease‬
‭if their salary remains constant, making them worse off. Higher wages causes an increased cost‬
‭of production for firms causing the short run aggregate supply to decrease from SRAS to‬
‭SRAS1 as firms are less willing and able to produce at this higher cost of production. At this‬
‭point Real GDP decreases from Y1 to Yfe and the economy is at its full potential where the‬
‭actual level of output (AD=SRAS) is equal to the potential level of output. However the average‬
‭price level has increased from PL3 to PL4.‬
‭ ne example of hyperinflation can be seen in Venezuela. Hyperinflation is when the rate of‬
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‭inflation grows at more than 50% a month. In the early 1920’s Venezuela discovered oil and‬
‭annual production increased rapidly over the next few decades and accounted for the majority‬
‭of the country's total exports. However, in the 1980’s oil prices decreased rapidly causing‬
‭Venezuela’s economy to contract and inflation to increase whilst simultaneously incurring large‬
‭amounts of government debt. In the 2010s, Venezuela’s government decided to print money‬
‭during urgent times to fund government spending as it was quicker than borrowing money‬
‭(which would have been difficult as the country was already in massive amounts of debt) or‬
‭receiving money from tax revenue. However, this exacerbated the country's inflation as creating‬
‭new money will eventually lead to average price levels in an economy to rise as well. This‬
‭happens because as more money circulates, people have extra money to spend (this increases‬
‭the consumption component of aggregate demand as consumer wealth is increasing).‬
‭Therefore aggregate demand increases as consumption increases. Sellers notice this higher‬
‭demand and may raise prices for their products which leads to more inflation. Furthermore,‬
‭people's behavior may change if they expect future price increases brought on by an increase in‬
‭the money supply. Firms may raise prices in advance in expectation of increased expenses‬
‭while consumers may increase their spending in anticipation of price increases which increases‬
‭the consumption component of aggregate demand. This causes the average price levels in the‬
‭economy to increase leading to even higher rates of inflation which is how Venezuela‬
‭snowballed into hyperinflation over the past decade with prices rising in the hundreds of‬
‭percentage from 2015, rising 121.74% compared to the year before and rising 65,374% in 2018‬
‭compared to 2017.‬

‭ ne significant consequence of inflation is that purchasing power and real incomes in an‬
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‭economy can decrease if wages are not increasing at the same rate of inflation due to factors‬
‭such as contracts which are binding over a given period of time and may not take into account‬
‭inflation rates in an economy. This is evident in Venezuela as wages were only rising on‬
‭average 60% compared to the average price levels in the economy which were rising by‬
‭hundreds of percentages, leading to a decrease in households purchasing power making them‬
‭worse off.‬
‭ eflation is the sustained decrease in average price level over time. This is caused by an‬
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‭decrease in Aggregate Demand. This decrease is due to an increase in one or more of the‬
‭Aggregate Demand components including consumption spending, investment spending,‬
‭government spending, and spending on exports minus imports (C + G + I + (X - M)). For‬
‭example a decrease in consumer confidence caused by the uncertainty of future job stability‬
‭can lead to an decrease in consumer spending as consumers are less willing to spend. This‬
‭decrease in consumer spending causes AD to decrease from AD to AD1 as there is a lesser‬
‭total demand for goods and services in the economy. When AD decreases, the real GDP also‬
‭decreases from Yfe to Y1 as Real GDP can be measured through the same expenditure‬
‭approach as aggregate demand (therefore when consumer spending decreases so does the‬
‭level of economic activity). At this point the actual level of output (AD=SRAS) is less than the‬
‭potential output (Yinf>Yfe) and the rate of unemployment is greater than the natural rate of‬
‭unemployment. This is because the decrease in the level of output means that firms require less‬
‭labor in order to continue producing at such a level thus demand for labor decreases and‬
‭unemployment increases.‬

‭ he classical perspective assumes that in the long-run the economy will correct itself as prices‬
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‭and wages are flexible. Therefore, when the average price levels in the economy decrease from‬
‭PL1 to PL2 because of the decrease in aggregate demand, this indicates to firms that they can‬
‭pay workers a lower wage. As individuals are rational decision makers from the classical‬
‭perspective, they will accept the lower wage. This is because when price levels in the economy‬
‭decrease their purchasing power will increase therefore their salary can decrease without‬
‭making them worse off. Lower wages cause a decreased cost of production for firms causing‬
‭the short run aggregate supply to increase from SRAS to SRAS1 as firms are less willing and‬
‭able to produce at this higher cost of production. At this point, Real GDP increases from Y1 to‬
‭Yfe and the economy returns to its full potential where the actual level of output (AD=SRAS) is‬
‭equal to the potential level of output. However the average price level has decreased from PL2‬
‭to PL3.‬
‭ ne example of deflation can be seen in Japan. In the 1980s, Japan witnessed an economic‬
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‭boom fueled by rapid growth, technological advancements, and a soaring stock market. Real‬
‭estate and stock prices reached unsustainable levels during this period. In the early 1990s, the‬
‭Japanese stock market crashed, leading to a significant decline in asset values. Major banks‬
‭faced a crisis due to bad loans linked to the collapsed real estate bubble. The bursting of the‬
‭asset bubble triggered an economic slowdown. Japan’s economy struggled to recover from the‬
‭burst bubble as wages remained stagnant, limiting consumer spending. From 2010 to 2018, the‬
‭increase in real wages totaled only 1.2% for the entire eight-year period. Due to limited‬
‭consumer spending (a component of aggregate demand), the overall levels of aggregate‬
‭demand in the economy were not able to increase in order to increase the average price levels‬
‭and return to the equilibrium level.‬

‭ significant consequence of deflation is that it’s difficult to correct deflationary spirals. This is‬
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‭because as prices decline, consumers anticipate further reductions. They delay their purchases,‬
‭expecting even lower prices in the future which leads to decreased consumer spending. In‬
‭1990, the year when the asset price bubble burst in Japan, the consumer price index (CPI) in‬
‭Japan was at its peak, reaching 100.0. By 2000, the CPI had fallen to around 90.0, indicating a‬
‭decline in prices. Personal consumption expenditure in Japan decreased from 71.2 trillion yen in‬
‭1990 to 68.2 trillion yen in 2000. Therefore, businesses face declining demand for their‬
‭products. Then with reduced sales, firms experience lower profits. To cope with lower profits,‬
‭firms reduce production leading to job losses and increased unemployment. This is evident in‬
‭Japan as between 1990 and 2000, Japan experienced a significant decline in industrial‬
‭production. For example, the index of industrial production dropped from 108.5 in 1990 to 96.6‬
‭in 2000. During the same period, the unemployment rate in Japan increased from 2.1% in 1990‬
‭to 4.7% in 2000. The rising unemployment further decreases consumer spending which causes‬
‭the economy to spiral deeper into deflation as the cycle repeats itself.‬

‭ herefore, deflation poses a greater risk to an economy as it can lead to decreased consumer‬
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‭spending, lower demand for goods and services, and increased unemployment. The anticipation‬
‭of lower prices may cause consumers to delay purchases, which can result in a deflationary‬
‭spiral which is difficult to correct. In contrast, although purchasing power is at risk, during‬
‭inflationary gaps the unemployment rate is less than the natural rate of unemployment as‬
‭increased demand stimulates production and job creation. Inflation can also be addressed using‬
‭monetary or fiscal policies to reduce aggregate demand while they are not effective when‬
‭addressing deflation. Therefore, the impact of deflation on an economy is typically more‬
‭significant and challenging to address compared to the consequences of inflation making it a‬
‭greater risk to an economy.‬