The Consequences Of Deflation On A Macroeconomic Level

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This essay will seek to examine and critically analyse the consequences of deflation on a macroeconomic level. Economic theory will be drawn from to aid comprehension of deflation and its effect on the economy. Articles from Financial times will be used as case studies to better understand the practical effects of deflation. The implications and effect these have on an economy will be explored, particularly focusing on governments and business deal with deflation.
Defining Deflation
Inflation refers to the rate at which prices for goods and services rises. How is it calculated?
Deflation is a complex phenomenon however the most widely adopted definition is a “sustained fall in a weighted average of all prices” (David Bae, 2014, 47). Although accurate and concise, the definition only offers a simplistic explanation. It fails to address the causal reasons of declining prices which are required to ascertain whether the deflationary period is either harmful or benign for the economy. Deflation arises from two main causes; falling levels of aggregate demand and increase in productive potential (Horwitz, 2014, 144-145). In defining deflation, General Equilibrium Theory offers a basis on which to better appreciate the relationship it shares with the economy. Under general equilibrium theory, the aggregate supplied should equal the aggregate demanded at the current given price, enabling effective distribution of goods and services within an economy. Here, price is the equaliser and acts to balance demand and supply; when this occurs the economy is in monetary equilibrium (Levin, 2006). Through understanding basic equilibrium theory, a clearer view of how price effects aggregate supply and aggregate demand is provided. This also highligh...

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...he effect this has on the labour market. Highlighted in picture 2, the wage rate is above the market clearing equilibrium level. This shows the population wants to supply Q3 amount of labour in exchange for W2 wage rate. However businesses are unable to offer this, and respond by only hiring Q2 amount in exchange for W2 wage rate. This results in the supply of labour exceeding the demand for labour. The remaining surplus of labour is defined as real rage unemployment. Between 1929 and early 1932, Germany experienced severe real wage unemployment caused by severe deflation during the Great Depression. Consequently, Germany’s unemployment rose from little under 1.3 million to over 6 million within three years (Dimsdale et al, 2004).
DIMSDALE – http://www.economics.ox.ac.uk/materials/papers/2292/56dimsdale.pdf
https://www.imf.org/external/pubs/ft/wp/2015/wp15229.pdf

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