Previous Year Question
Which one of the following statements is an appropriate description of deflation?
It is a sudden fall in the value of a currency against other currencies.
It is a persistent recession in both the financial and real sectors of the economy.
It is a persistent fall in the general price level of goods and services.
It is a fall in the rate of inflation over a period of time.
Correct Answer: C
Detailed Solution
Deflation is a sustained decline in the general price level of goods and services.
During Deflation, the inflation rate becomes negative:
Where:
Pt = वर्तमान अवधि का Price Index
Pt-1 = पिछली अवधि का Price Index
Numerical example
If CPI was 200 in the previous year and declines to 196:
This represents Deflation of 2%.
In contrast, if CPI increases from 200 to 204, prices have increased by 2%; it is not Deflation.
Possible causes of Deflation
Deflation may arise from:
A sharp contraction in Aggregate Demand
Contraction of Money Supply and Credit
A Banking Crisis
Large-scale debt repayment and deleveraging
Declining Government and private expenditure
Demand remaining below productive capacity
A substantial supply increase resulting from rapid productivity growth
Economic effects of Deflation
Deflation may initially appear beneficial to consumers because prices decline. However, persistent economy-wide Deflation may create serious problems:
Consumers may postpone purchases in anticipation of still lower prices.
Business revenue and profits may decline.
Production and employment may contract.
Nominal wages may come under downward pressure.
The real burden of fixed debt increases.
Loan defaults and banking stress may rise.
The Real Interest Rate relationship is:
If the Nominal Interest Rate is 3% and inflation is -2%:
Thus, even with a low Nominal Interest Rate, the Real Interest Rate may remain high during Deflation.
Option (a) is incorrect
A decline in the domestic currency’s value relative to another currency is called Currency Depreciation or Devaluation.
It concerns the Exchange Rate, not a persistent decline in the domestic general price level.
Option (b) is incorrect
A persistent contraction in the financial and real sectors may describe an Economic Recession or Depression.
A recession can be accompanied by Deflation, but the two concepts are not identical. Inflation may also coexist with economic stagnation following a supply shock.
Option (d) is incorrect
A decline in the inflation rate while it remains positive is called Disinflation.
For example:
Inflation in the first year = 8%
Inflation in the next year = 5%
Prices are still increasing by 5%. Therefore, this is not Deflation.
Deflation occurs only when inflation becomes negative and the general price level actually declines.
Comparison
Condition | Change in price level |
Inflation | Prices increase |
Disinflation | Prices increase at a slower rate |
Deflation | Prices actually decline |
Hyperinflation | Prices increase at an extremely rapid rate |