Deflation — why falling prices can be dangerous — Economics

Before this

This leads to

When cheaper becomes heavier

The last lecture ended with a promise: when prices fall, every debt grows in real terms, and borrowers become the losers. Here is that picture, turned upside down.

Tendai (invented) borrows $50 000 for one year at 3% interest. This time, prices fall by 5% during the year. At the end of the year he repays $51 500, as agreed. But each dollar now buys more than it did. In start-of-year prices, his repayment is worth $51500 \div 0.95 \approx 54211$ dollars. He planned to pay back about $1 500 of extra buying power. He has paid back about $4 211.

Shoppers like falling prices. So it may seem strange that central banks fight hard to avoid them. Japan's consumer prices drifted down for most of the years from 1998 to 2012, and the Bank of Japan spent more than two decades trying to lift them. This lecture explains why economists fear a general fall in prices. It also explains why not every fall in prices is a problem.

What deflation is, and what it is not

Deflation is a sustained fall in the general price level. In other words, the inflation rate is negative, and it stays negative. If a price index falls from 100 to 98 in one year, the inflation rate is $- 2%$ .

Two other things are often confused with it.

Disinflation is a fall in a positive inflation rate. If inflation falls from 6% to 2%, prices are still rising, only more slowly. That is disinflation, not deflation.
A fall in one price is a change in a relative price. Televisions and phones have become cheaper for decades while the general price level rose. That is not deflation either.

The word "sustained" matters too. In January 2015, prices in the euro area were 0.6% lower than a year before (Eurostat). Most of that came from energy, whose prices were 8.9% lower, while the prices of services were still rising. The European Commission said at the time that this was not genuine deflation. A fall in the oil price had pulled the index down, but it did not start a general, lasting fall in prices.

Two very different reasons for falling prices

The causes-of-inflation lecture used aggregate demand (AD) and aggregate supply (SRAS and LRAS) to explain why prices rise. The same diagram shows two ways in which the price level can fall.

Supply-led deflation. Productivity grows fast. Firms can make more with the same workers and machines, so their costs fall. SRAS and LRAS shift right. The price level falls, but output rises. People are better off: their incomes buy more because the economy produces more.

Demand-led deflation. Spending collapses, perhaps after a crash in share or house prices. AD shifts left. The price level falls, and output falls with it. Firms sell less, so they need fewer workers. This is the dangerous kind.

Try both on the diagram below.

Graph builder — two ways for prices to fall

An invented economy starts at a price level of 100 and real GDP of 100, at its potential output. Move the first slider to make spending fall (AD shifts left). Move the second to make productive capacity grow (SRAS and LRAS shift right). Grey dashed lines show the start. Watch what happens to output in each case.

Fall in spending: 0

Growth in productive capacity: 0

Try:

Grey dashed: before. Brown: after. AD slopes down; SRAS slopes up; LRAS is vertical at potential output.

Three cases in an invented economy that starts with a price level of 100 and real GDP of 100, at its potential output.

Spending falls (AD shifts left). The price level falls to 94 and real GDP falls to 94. Potential output is still 100, so there is spare capacity of 6. Firms need fewer workers. This is demand-led deflation.
Capacity grows (SRAS and LRAS shift right). The price level falls to 94, but real GDP rises to 106, which is the new potential output. There is no spare capacity. This is supply-led deflation.
Both happen. The price level falls to 92. Real GDP stays at 100, but potential output is now 104, so there is spare capacity of 4. The demand part is the dangerous part.

What should you have seen? Both sliders lowered the price level. Only the fall in spending left the economy producing less than it could. So the price level alone cannot tell you whether deflation is harmful. You must ask what caused it, and what is happening to output.

History has examples of both kinds. In the United States and Canada between about 1870 and 1896, prices fell on average while output grew. In Canada, prices fell by about 0.4% a year while real GDP grew by about 2.4% a year (Bordo and Redish, NBER, 2003). Their study found that output growth in the United States in this period came almost entirely from supply. The Great Depression of the 1930s was the opposite case. In the United States between 1929 and 1933, consumer prices fell by 25%, real GDP fell by 29%, and unemployment reached 25% (Federal Reserve Bank of St. Louis).

Stop and think

The euro area's prices fell by 0.6% in the year to January 2015, mostly because oil became cheaper. Which kind of deflation was this closer to, and why did the European Commission not call it genuine deflation?

Show the answer

It was closer to supply-led. Cheaper oil lowers firms' costs, which shifts SRAS right, so it pushes prices down without first cutting spending. The Commission's point was the word "sustained". A fall in one large price can make the index fall for a few months. Deflation means a general fall that lasts. Services prices were still rising, so the fall was not general. Even so, central banks watch cases like this closely, because a temporary fall can change what people expect.

How falling prices can feed on themselves

Demand-led deflation is feared because it can create its own next round. Three channels do this.

1. Waiting to buy. If a car will be cheaper next year, some buyers wait. Firms then sell less now. Economists disagree about how strong this effect is when prices fall slowly, by 1% or 2% a year. It is most likely for large purchases that can be delayed, such as cars, machines and buildings.

2. Debts grow. This is the channel the last lecture promised. A debt is fixed in money, so when the price level falls, the real value of every debt rises. Before reading on, make a prediction.

Predict — a debt when prices fall

Someone owes $100 000. Over the next few years, the general price level falls by 10%, and the debt is unchanged. By how much has the real value of the debt risen? Choose before you see the answer.

The answer is about 11.1%, not 10%. The real value of the debt is the money amount divided by the price level. The price level is now 0.9 times what it was, so the debt is worth $100000 \div 0.9 \approx 111111$ dollars in the old prices. That is a rise of about 11.1%.

So debtors lose more than the fall in prices suggests. Their incomes usually fall with prices, but the payments they owe do not. To keep up with the payments, they cut spending and sell what they own, such as houses, shares or unsold goods. When many people sell at once, prices fall further, and real debts rise again. The American economist Irving Fisher described this chain in 1933, in a paper called "The Debt-Deflation Theory of Great Depressions". He was explaining the disaster around him. Between 1930 and 1933, about 7 000 banks in the United States failed, nearly a third of the banking system (Federal Reserve Bank of St. Louis). When borrowers cannot repay, the banks that lent to them are in trouble too.

Worked Example 1 — A household's debt in a deflation (invented)

Amara owes $150 000 on her home and earns $50 000 a year. For four years, prices fall by 3% a year, and her pay falls by 3% a year as well. She pays only the interest, so the amount she owes stays at $150 000. What happens to her debt compared with her income?

After four years her pay is $50000 \times 0.9 7^{4} \approx 44265$ dollars.

At the start, her debt was $150000 \div 50000 = 3.0$ times her income. Now it is $150000 \div 44265 \approx 3.39$ times her income.

In start-of-period prices, her debt is now worth $150000 \div 0.9 7^{4} \approx 169435$ dollars, about 13% more than she borrowed. Her real pay has not changed at all, but her real debt has grown.

Check: $3.0 \div 0.9 7^{4} \approx 3.39$ . ✓ The debt-to-income ratio rises by the same factor as the real debt, because her real pay stayed the same.

3. Pay that does not fall easily. Firms find it hard to cut workers' pay, and workers resist cuts. So when prices fall and pay stays the same, each worker costs the firm more in real terms. Firms respond by hiring fewer people, and unemployment rises. Less income then means less spending.

The deflationary spiral. Each step makes the next one more likely. The spiral starts from a fall in spending, not from cheaper production.

The three channels meet in the figure above. Each person's choice makes sense on its own: waiting for lower prices, paying down debt, protecting the firm. But when everyone makes the same choice, spending falls for the whole economy. That is the hard part of this lecture, so read it again. Sensible choices by individuals can together produce a result that is bad for all of them.

The floor under interest rates

When spending falls, a central bank normally cuts interest rates. Cheaper borrowing encourages households and firms to spend and invest. The monetary policy lecture explains how. Deflation blocks this tool in two ways.

First, interest rates cannot go far below zero. Cash pays an interest rate of exactly 0%. If banks charged savers much less than zero, people could take their money out and hold notes instead. Holding large amounts of cash is costly and risky, so rates a little below zero are possible. The Bank of Japan used a rate of $- 0.1%$ on part of the money banks kept with it, from 2016 to 2024 (Bank of Japan). But there is a floor not far below zero. Economists call it the zero lower bound.

Second, deflation raises the real interest rate. The last lecture showed how to find it by dividing growth factors:

1 + real rate = \frac{1 + nominal rate}{1 + inflation rate}

With a nominal rate of 0% and prices falling by 3% a year, $1 + r = 1 \div 0.97 \approx 1.031$ . So the real interest rate is about 3.1%. Borrowing is expensive in real terms, even though the nominal rate is zero.

Worked Example 2 — The real rate a central bank cannot reach (invented)

Prices in a country are falling by 2% a year. Its central bank believes the economy needs a real interest rate of $- 1%$ to make people spend again. What nominal rate would that need?

Rearrange the formula: $1 + i = (1 + r) (1 + π) = 0.99 \times 0.98 \approx 0.970$ .

So the nominal rate would have to be about $- 3.0%$ . Savers would hold cash rather than accept that, so the central bank cannot set it. At a nominal rate of 0%, the real rate is $1 \div 0.98 - 1 \approx + 2.0%$ , three points above what the economy needs.

Check: $0.970 \div 0.98 \approx 0.990$ , a real rate of $- 1%$ . ✓

Stop and think

Two economies have the same nominal interest rate, 0%. In one, prices rise by 2% a year. In the other, they fall by 2% a year. In which one is borrowing to build a factory more attractive, and by how much?

Show the answer

In the economy with rising prices. There the real rate is $1 \div 1.02 - 1 \approx - 2.0%$ : the factory's future sales come in at higher prices, while the loan stays fixed. With falling prices the real rate is about $+ 2.0%$ . The gap is about 4 points of real interest, with the same nominal rate. This is why a central bank in deflation can be stuck even at zero.

A real case: Japan, 1990 to 2024

The background. In the late 1980s Japan's share and land prices rose to extraordinary levels. The Nikkei share index peaked at 38 915.87 on 29 December 1989. By March 2003 it had fallen to 7 862, about 80% lower. Land prices fell for years from 1992. Many borrowers could not repay, and banks carried large amounts of bad loans.

The policy. The Bank of Japan cut its main interest rate from 6% in August 1990 to 0.25% in September 1998 (Bank of Japan). Consumer prices excluding fresh food began to fall in the second half of 1998. In February 1999 the Bank brought its rate to virtually zero and promised to keep it there "until deflationary concern is dispelled". It raised the rate in August 2000, a step many economists later judged too early. From March 2001 to March 2006 it created large amounts of money, a policy called quantitative easing.

The prediction. Interest rates at zero, and then plenty of new money, were expected to end the price falls and restart growth.

What happened. The deflation was mild but stubborn. The lowest annual inflation rate was about $- 1.35%$ , in 2009 (World Bank). But prices excluding fresh food fell again in 2012, by 0.1%, the fourth year of decline in a row (Ministry of Internal Affairs and Communications). In January 2013 the Bank set a 2% inflation target. In April 2013 it began a much larger programme of money creation and aimed to reach 2% in about two years. In 2016 it added the negative rate. The 2% target was still not met years later. Inflation finally rose in 2022, when import prices jumped and the yen fell. Prices excluding fresh food rose 4.2% in the year to January 2023, the fastest since 1981. In March 2024 the Bank judged that 2% was "within sight", and it ended negative rates (Bank of Japan).

The verdict. Japan's deflation was never a dramatic spiral like the 1930s. Prices fell slowly. But once people expected prices to stay flat or fall, that expectation was very hard to change, and the central bank's main tool had already reached its floor. Economists still debate how much of Japan's slow growth came from deflation itself and how much from the banking problems and other causes. What the case shows clearly is that deflation is far easier to enter than to leave.

Three classic mistakes

Trap 1 — Calling disinflation deflation

"Inflation fell from 5% to 1%, so prices fell" is wrong. Prices rose by 1%. Deflation needs a negative inflation rate. When the inflation rate falls but stays positive, that is disinflation.

Trap 2 — Judging deflation by the price level alone

Falling prices are not always bad, and not always good. Ask what caused them. Supply-led falls come with rising output. Demand-led falls come with falling output and rising unemployment. A strong answer names the cause and what is happening to real GDP.

Trap 3 — Subtracting instead of dividing

A 10% fall in prices raises the real value of a debt by about 11.1%, not 10%, because $1 \div 0.9 \approx 1.111$ . In the same way, a 0% nominal rate with $- 3%$ inflation gives a real rate of about 3.1%, not exactly 3%. Divide growth factors.

Try it yourself

Work each one on paper first. Open a hint only when you are stuck.

A country's price index is 100 in 2024, 102 in 2025, 103 in 2026 and 101.5 in 2027. Find the inflation rate for each year from 2025 to 2027, and name what is happening in each year: inflation, disinflation or deflation.

Hint 1
Inflation rate = (new index ÷ old index − 1) × 100.

Hint 2
Disinflation means the rate is still positive but lower than the year before. Deflation means the rate is negative.

Full answer
2025: $102 \div 100 - 1 = 2.0%$ : inflation. 2026: $103 \div 102 - 1 \approx 0.98%$ : still inflation, but the rate has fallen, so this is disinflation. 2027: $101.5 \div 103 - 1 \approx - 1.46%$ : deflation. Check: $103 \times (1 - 0.0146) \approx 101.5$ . ✓
Kofi owes $40 000. Over three years, the price index falls from 100 to 92. What is his debt worth in the prices of the first year, and by what percentage has its real value risen?

Hint 1
Real value = money amount ÷ price index × 100.

Hint 2
$40000 \div 92 \times 100$ . Then compare with $40 000.

Full answer
$40000 \div 92 \times 100 \approx 43478$ dollars. The real value has risen by about $43478 \div 40000 - 1 \approx 8.7%$ , more than the 8% fall in prices. Check: $43478 \times 0.92 \approx 40000$ . ✓
A central bank has cut its rate to 0.5%. (a) Find the real interest rate if prices are falling by 1.5% a year. (b) Find it if prices are instead rising by 2% a year. (c) Explain, using your answers, why central banks fear deflation when rates are already low.

Hint 1
Use $1 + r = \frac{1 + i}{1 + π}$ . Falling prices mean $π$ is negative: $1 + π = 0.985$ .

Hint 2
(a) $1.005 \div 0.985$ . (b) $1.005 \div 1.02$ .

Full answer
(a) $1.005 \div 0.985 - 1 \approx 2.0%$ . (b) $1.005 \div 1.02 - 1 \approx - 1.5%$ . (c) With the same nominal rate, deflation makes the real rate about 3.5 points higher. The central bank cannot fix this by cutting much further, because the nominal rate is already close to its floor. So deflation makes borrowing dear in real terms at exactly the time the economy needs more spending. Check (a): $1.020 \times 0.985 \approx 1.005$ . ✓
A government owes $150 billion. Its country's nominal GDP is $100 billion, so the debt is 150% of GDP. Next year, real GDP grows by 1%. The government neither borrows more nor repays anything. (a) Find the debt as a percentage of GDP if prices fall by 2%. (b) Find it if prices instead rise by 2%. (c) What does this suggest about deflation for a country with large government debts?

Hint 1
Nominal GDP grows by the real growth factor times the price factor.

Hint 2
(a) Nominal GDP = $100 \times 1.01 \times 0.98$ billion dollars. Divide 150 by it.

Full answer
(a) Nominal GDP = $100 \times 1.01 \times 0.98 = 98.98$ billion dollars, so the ratio is $150 \div 98.98 \approx 151.5%$ . The ratio rises, even though the economy grew. (b) Nominal GDP = $100 \times 1.01 \times 1.02 = 103.02$ billion dollars, so the ratio is $150 \div 103.02 \approx 145.6%$ . (c) Debt is fixed in money, but the taxes that pay for it come from nominal incomes. Deflation shrinks nominal GDP, so the debt becomes a heavier burden, just as it does for a household. The same debt-deflation channel works for governments. Check (a): $98.98 \times 1.515 \approx 150$ . ✓

The bigger idea

Many central banks aim for inflation of about 2%, not 0%. One reason is this lecture. With inflation at 2%, nominal interest rates are usually well above zero in normal times. That leaves room to cut them when spending falls. A target of 0% would put the economy much closer to the floor, and a small shock could tip it into deflation. A little inflation is a safety margin.

This lecture closes the topic of inflation. Rising prices move buying power from lenders to borrowers. Falling prices move it back, and can drag a whole economy down with them. The monetary policy lecture will show what a central bank can still do when its interest rate is close to zero. The fiscal policy lecture will show what a government can do instead.

Key concepts in this lesson

Deflation is a sustained fall in the general price level, a negative inflation rate, and it is different from disinflation, which is a fall in a positive inflation rate.
Supply-led deflation comes from rising productivity, with prices falling and output rising, while demand-led deflation comes from falling spending, with prices and output falling together.
When prices fall, the real value of every debt rises, by the money amount divided by the price level, so debtors cut spending and sell assets, which can push prices down further.
Waiting to buy, rising real debts and pay that does not fall easily can turn demand-led deflation into a spiral of falling spending, output and prices.
Nominal interest rates cannot go far below zero, so deflation keeps real interest rates high and weakens a central bank's main tool, as Japan found from 1998 onwards.