3.3.6—Deflation and disinflation

Deflation is a sustained fall in the general price level. Disinflation is a fall in the inflation rate while prices are still rising.

A fall in AD can reduce output and prices; an increase in SRAS can lower prices while output rises. Persistent deflation can delay purchases, increase real debt burdens, weaken profits and raise cyclical unemployment.

When inflation falls from 6% to 3%, prices are still rising: this is disinflation. If the index falls from 100 to 98, the price level has fallen and the economy has experienced deflation.

Check the price-level series first, then identify whether the shock came through AD or supply before discussing the consequences.

A temporary price fall in one product is not economy-wide deflation, and disinflation is not automatically harmful.

Demand-side deflation is shown by AD shifting left, lowering the price level and real output; supply-side deflation is shown by SRAS shifting right, lowering the price level while raising real output. Persistent harmful deflation can increase uncertainty, redistribute toward creditors, postpone spending, increase cyclical unemployment and bankruptcies, raise the real value of debt, distort allocation and weaken monetary policy when nominal interest rates cannot fall enough. Diagnose the initiating curve before judging the outcome.