Question

(Related to the Apply the Concept on page 688 ) During the spring of $2015,$ the United Kingdom experienced a brief period of deflation. According to an article in the Wall Street Journal, "The U.K.'s history of sticky and hardto- control inflation suggests that a short period of falling prices will be taken as a reprieve for consumers, not as a signal to defer purchases." Why might consumers see deflation as a "signal to defer purchases"? Shouldn't lower prices cause consumers to buy more, not less? Briefly explain.

Short answer

In periods of deflation, consumers may defer purchases with the expectation that prices will continue to fall further in the future, allowing them to 'save' more by making their purchases later. While lower prices could encourage some consumers to buy more, the overall effect of deflation could significantly slow market activity and cause an economic downturn.

Step-by-step solution

Understand 'Deflation'

Deflation is a phenomenon of economic downturn where the price of goods and services fall over time. This is a completely opposite economic state compared to 'Inflation', where prices of goods and services typically rise.

Analyze Consumer Behavior in Deflation

In periods of deflation, while it might seem logical that consumers would take advantage of falling prices to buy more goods, in reality, they might defer their purchases. The reason behind this is the expectation that the prices will fall even further in the future. Consumers might think that they can save money by postponing their purchases. This all happens due to the expectation of a further decrease in prices as a result of deflation.

Discuss the Effects on Economy from Deferred Purchases

It's significant to note that while some customers defer purchases, hoping prices will drop even further, the economy, in turn, slows down because of decreased demand for goods and services. Hence, the reduced economic activity can lead to business closures and job losses. Despite their savings on individual prices, customers, as a whole, might face a devastated economy.

Key concepts

Consumer Behavior

Consumer behavior during deflationary periods can be quite complex. Deflation, a situation where prices generally decrease, might logically lead one to think that consumers would rush to buy cheaper products. However, the reality is less straightforward. Consumers often anticipate that if prices are falling, they might continue to fall, so why not wait a little longer for even lower prices? This mindset can lead to what's known as deferred purchasing behavior. While saving money is appealing, this behavior can have significant impacts on economic health.

It's important to understand the psychology behind this. People love getting a good deal, so the possibility of prices dipping further in the future can be tempting. Nonetheless, the risk is that if everyone starts deferring purchases, businesses might suffer from reduced sales. This kind of consumer behavior can contribute to prolonged economic downturns.

Economic Downturn

An economic downturn is typically characterized by reduced economic activity and can be exacerbated by deflation. As consumers hold back on their spending, waiting for prices to fall further, the demand for products and services diminishes. This lack of demand can have a ripple effect across the economy.

Companies might see their revenues drop, leading them to cut costs, which often involves reducing their workforce. As unemployment rises, even fewer people can afford to spend money, leading to a vicious cycle. Furthermore, businesses may become hesitant to invest or expand, given the uncertainty of future revenues.

Economic downturns affect everyone, not just those actively involved in buying and selling goods, making them a significant challenge for policymakers seeking to stimulate growth.

Prices and Demand

Prices and demand have a close yet complex relationship, especially during periods of deflation. Normally, we expect that when prices drop, demand would increase because consumers appear to get more value for their money. However, in a deflationary context, this is not always the case.

As prices fall, the expectation can be set that they will continue to decrease, encouraging consumers to wait it out rather than spend immediately. This can lead to less demand in the short term, despite lower prices. Businesses might then struggle to sell their goods and services, which can prompt further price cuts in attempts to stimulate sales, further deepening deflation.

Understanding this dynamic helps illustrate why simple economic theories that predict constant increases in demand with falling prices don't always hold in real-world deflationary contexts.

Inflation Comparison

Understanding deflation also involves comparing it with inflation, the opposite phenomenon where prices tend to rise. In inflationary times, consumers might rush to buy now, to avoid paying more later, leading to an increase in demand. This can sometimes result in a healthy economy, provided inflation doesn't escalate out of control.

Conversely, in deflationary times, deferring purchases becomes more common. Inflation can encourage spending and investment, stimulating economic growth. Deflation, on the other hand, tends to slow down economic activity, as lower spending leads to reduced business revenues and can result in job losses.

Both deflation and inflation offer challenges, but they require different strategies to manage. Policymakers often find themselves balancing these forces to maintain a stable economic environment.