Deflation

Defined as a sustained fall in the general level of prices, deflation can be the result of a sudden decline in economic activity.

Its immediate effect is to make consumers reduce their purchases in the expectation of being able to buy more cheaply at a later date. A less obvious but more important effect is to require borrowers to repay more in real terms than they had borrowed. (for example, if prices declined by 20 percent, a farmer who had previously borrowed £100 to buy ten pigs would have to repay the equivalent of twelve pigs). Another effect is to require employers to pay their employees the same wages despite a reduction in income from their employees' output - or, to put it another way, to pay higher real wages for the same level of real output.

Thus deflation can disrupt the economy by prompting consumers to delay their purchases, borrowers to default on repayments and employers to dismiss their employees. Each of those responses intensifies the initial decline in activity, and each further decline in activity intensifies the responses that produced it - and so on in a devastating spiral of economic decline and rising unemployment.

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