Classwork Series and Exercises {Economics – SS2}: Deflation

Economics, SS 2, Week 8

Topic: Deflation

Content:

1. Meaning of deflation
2. Causes of deflation
3. Effects of deflation
4. Control of deflation

Meaning of Deflation

It is a general decline in prices, often caused by a reduction in the supply of money or credit.

It is defined as the continuous or persistent fall in the price level of goods and services as a result of the decrease of money in circulation.

Deflation can be caused also by a decrease in government, personal or investment spending. The opposite of inflation, deflation has the side effect of increased unemployment since there is a lower level of demand in the economy, which can lead to an economic depression.

Central banks attempt to stop severe deflation, along with severe inflation, in an attempt to keep the excessive drop in prices to a minimum.

Causes of Deflation

The following points below are the causes of deflation

1. Increase in bank rate: This helps to discourage commercial banks from borrowing from the central bank and by so doing reduces the bank’s ability to lend money, leading to a reduction in money circulation.
2. Increase in taxation: When taxation is increased, it will definitely reduce the volume of money in circulation thereby causing deflation to occur.
3. Budget surplus: It is a device by which the rate of injecting money into the circulation was reduced.
4. Increase in production: Consistent increase in the production of goods without a corresponding increase in the circulation of money will lead to deflation.

Effects of Deflation

The following are the effects of deflation

1. It results into unemployment: Deflation brings about unemployment in the labor market.
2. Reduction in investment
3. Decline in profits
4. It encourages savings
5. Fixed income earners gain
6. It brings about increase in the value of money
7. It will bring about fall in the prices of goods and services.
8. It encourages exports
9. It discourages imports.

Control of Deflation

Deflation can be controlled in the following ways

1. The use of open market operation: This occurs when the central bank purchases securities from commercial banks, this makes it possible for the commercial banks to be able to lend money out and increase the volume money on circulation.
2. The use of deficit budgeting: An increase in government expenditure helps to inject more money into circulation by curbing the effects of deflation.
3. Reduction in bank rate: Reduction in bank rate will help to assist investors to borrow more money from banks thereby increasing the volume of money in circulation.
4. Increase in wages and salaries: This will help to inject more money into circulation thereby controlling deflation.
5. Reduction in Taxation: Reduction will help to have more money thereby increasing their purchasing power and controlling deflation.

Test and Exercise

1. The consistent and persistent fall in the price of goods and services is (a) inflation (b) deflation (c) reflation (d) disinflation.
2. The causes of deflation are except (a) increase in taxation (b) budget surplus (c) increase in bank rate (d) increase in demand.
3. Deflation can be controlled by (a) Reduction in taxation (b) increase in taxation (c) use of open market operation (d) increase in wages and salaries.
4. The following are effect of deflation (a) It results into employment (b) creditors gain (c) reduction in investment (d) encourages import.
5. Inflation and deflation can actually be controlled. True/ false.

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