Deflation summary

Deflation, just like inflation is caused by two main things:

Demand side - When AD falls due to a lack of consumption, investment or government spending. This can cause a DEFLATIONARY SPIRAL which is very bad.

Supply side - A reduction in production costs or corporation tax etc. This is usually the "better" type of inflation.

A deflationary spiral is caused by:

•  Consumers delay their consumption waiting for the lowest prices.
• Reduces the effect of interest rates. Real interest rate is always positive during deflation and so consumers have an incentive to save their money in banks.
• Increases the real value of debt because wages will fall but the nominal value of debt is constant to it costs more to pay it back.

This graph shows what happens when AS shifts out and AD shifts in. Output has not changed and maintains at "Y" but the price level has fallen from P to P2.