Deflationary Spiral

Definition

A deflationary spiral is a self-reinforcing cycle of decreasing prices and economic contraction. It occurs when falling prices lead to a decrease in demand, production, and investment, further driving down prices and perpetuating the cycle of economic decline.

5 Must Know Facts For Your Next Test

1. A deflationary spiral can lead to a prolonged recession or depression as consumers and businesses postpone spending, further reducing aggregate demand.
2. Falling prices can cause consumers to delay purchases, expecting lower prices in the future, leading to a further drop in aggregate demand.
3. Businesses may respond to falling demand by cutting production and investment, leading to higher unemployment and lower incomes, which further reduces aggregate demand.
4. Deflation can increase the real value of debt, making it more difficult for consumers and businesses to repay loans, leading to financial instability.
5. Governments and central banks may intervene with expansionary monetary and fiscal policies to try to break the deflationary spiral and stimulate the economy.

Review Questions

• Explain how a deflationary spiral can arise in the context of the AD/AS model.
  • In the AD/AS model, a deflationary spiral can occur when a decrease in aggregate demand leads to a fall in the general price level. This decrease in prices causes consumers to delay purchases, further reducing aggregate demand. Businesses respond by cutting production and investment, leading to higher unemployment and lower incomes, which in turn reduces aggregate demand even more. This self-reinforcing cycle of falling prices and economic contraction is known as a deflationary spiral.
• Describe the potential consequences of a deflationary spiral on economic growth, unemployment, and financial stability.
  • A deflationary spiral can have severe consequences for an economy. The prolonged decrease in aggregate demand can lead to a recession or depression, as consumers and businesses postpone spending. This can result in higher unemployment, as businesses cut production and investment. Additionally, the increase in the real value of debt can make it more difficult for consumers and businesses to repay loans, leading to financial instability and potentially a credit crisis. Governments and central banks may need to intervene with expansionary policies to try to break the deflationary spiral and stimulate economic growth.
• Evaluate the role of monetary and fiscal policies in addressing a deflationary spiral, and explain how they can help to stabilize the economy.
  • Governments and central banks can use a variety of monetary and fiscal policies to try to break a deflationary spiral and stabilize the economy. Expansionary monetary policies, such as lowering interest rates or increasing the money supply, can stimulate aggregate demand and encourage consumer and business spending. Fiscal policies, such as increasing government spending or cutting taxes, can also help to boost aggregate demand and offset the effects of the deflationary spiral. Additionally, policies that address the underlying causes of the deflationary spiral, such as addressing financial instability or promoting investment, can help to stabilize the economy and prevent the self-reinforcing cycle of declining prices and economic contraction.

Related terms

Deflation: A sustained decrease in the general price level of goods and services in an economy, the opposite of inflation.

Aggregate Demand: The total demand for all goods and services in an economy at a given time and price level.

Aggregate Supply: The total quantity of goods and services that producers are willing and able to sell at different price levels in a given time period.