When Prices Drop but So Does Your Mood: The Devious Truth About Deflation

When Prices Drop but So Does Your Mood: The Devious Truth About Deflation

Today we're diving into the financial plot that makes bargain hunters cheer but economists lose sleep – DEFLATION!

"Everything Must Go!" – When Discounts Aren't Actually Good News

Imagine this: You're scrolling through Amazon and notice that literally EVERYTHING, and here I mean absolutely everything, is cheaper than last month. Your favourite trainers? 5% off. That overpriced phone you've been eyeing? 10% cheaper. Even your weekly Tesco shop costs less!

Sounds like a dream, right?

Economists nervously enter the blog...

Here's the issue: when prices across the entire economy start falling and keep falling, we've entered the twilight zone known as deflation. It's like when Netflix drops their subscription price – seems brilliant until you realise it probably means they're in serious trouble!

Deflation: The "Buy Later" Economy

Deflation is basically negative inflation – prices aren't just rising more slowly (that's disinflation, which we'll get to), they're actually dropping month after month.

Remember that episode of Friends where Ross keeps yelling "MY SANDWICH"? Well, deflation is what happens when the entire economy starts shouting "MY PRICES!" as they watch their value shrink.

The Two Faces of Deflation: Dr. Jekyll and Mr. Hyde

Not all deflation is created equal. There's actually "good deflation" (benign) and "I'm-going-to-destroy-your-economy" deflation (malign). Let me break it down:

Benign Deflation: The Good Twin

Imagine you're playing Minecraft and suddenly discover a way to mine resources twice as fast. You can now make more stuff without using extra time or energy. That's basically what happens with benign deflation – the economy becomes more efficient at producing things.

When companies find better ways to make their products (think robots, AI, or just smarter processes), they can produce more stuff more cheaply. This shifts the aggregate supply curve outward.

Real-world example: Remember when flat-screen TVs first came out and cost thousands of pounds? Now you can grab a decent one for a couple hundred quid. That price drop wasn't because the economy was in shambles – it was because technology improved and manufacturing became more efficient. That's benign deflation at work!

Visualise it as economists speak:

• Aggregate supply increases (shifts right)

• Prices fall from PL1 to PL2

• Output increases from Y1 to Y2

• Everyone's actually better off!

Malign Deflation: The Evil Twin

Now for the dark side. Malign deflation is like when everyone at school suddenly decides your birthday party is going to be lame so nobody shows up. Ouch.

This happens when people and businesses just... stop spending money. Maybe there's a financial crisis (hello 2008!), maybe there's a global pandemic (looking at you, 2020), or maybe everyone's just feeling pessimistic about the future.

Whatever the cause, when people stop buying stuff, businesses make less money, so they lay off workers, who now have less money to spend... and the whole miserable cycle continues.

Real-world example: Japan has been stuck in a deflationary trap since the 1990s. They call it the "Lost Decades." Property prices crashed, wages stagnated, and the economy basically flatlined for 20+ years. Even with interest rates at basically zero, people still wouldn't borrow and spend. It's like the economic equivalent of quicksand – the more you struggle, the deeper you sink!

As we economists say:

• Aggregate demand decreases (shifts left from AD1 to AD2)

• Prices fall from PL1 to PL2

• Output decreases from Y1 to Y2

• Jobs disappear and everyone's miserable!

Disinflation vs. Deflation: The "Not As Bad But Still Not Great" Cousin

Quick detour – let's clear up a common confusion. Disinflation isn't the same as deflation:

• Deflation: Prices are actually falling. Your £5 chai latte from last year now costs £4.75. The inflation rate is negative (-5%).

• Disinflation: Prices are still rising, just more slowly than before. Your chai latte that went from £4 to £5 last year (25% increase) only goes up to £5.25 this year (5% increase). The inflation rate is positive but decreasing.

Disinflation is like when your annoying little brother is still bothering you, just less intensely. Deflation is when he's left the room entirely but taken your phone with him.

Why Deflation Is Scarier Than a Horror Film Marathon

Let's get into why economists would rather deal with moderate inflation than even a touch of deflation:

1. The "I'll Buy It Tomorrow" Problem

Imagine you're about to buy the latest iPhone, but your mate tells you, "Wait a month, it'll be 5% cheaper." So you wait. Then next month they say, "Actually, wait another month, it'll be another 5% cheaper."

Before you know it, you're 87 years old and still haven't bought a phone because prices keep falling! This is the deflation trap – why buy today when it will be cheaper tomorrow?

When everyone thinks this way, the economy grinds to a halt. It's like when everyone's waiting for someone else to make the first move at a school dance – nothing happens!

2. Debts Become Weight Training for Your Finance

Got student loans? A mortgage? During deflation, those debts actually get HEAVIER.

Let's say you borrowed £30,000 for uni. With 2% inflation, that debt effectively shrinks by about £600 a year in real terms. But with 2% deflation, it grows by £600 annually even if you're making payments!

It's like those nightmare video games where the enemies get stronger the longer you play.

Real-world example: After the 2008 financial crisis, many UK homeowners found themselves in "negative equity" – owing more on their mortgage than their house was worth. With property prices falling and debts remaining the same, people were effectively trapped in their homes, unable to sell without going bankrupt.

3. The Unemployment Tsunami

When businesses make less money because everyone's waiting for lower prices, guess what's the first cost they cut? Yep, staff.

During Japan's deflationary period, their traditional "job for life" culture crumbled. Companies couldn't afford to keep everyone on, leading to a rise in temporary contracts and youth unemployment.

The UK saw similar issues during the austerity years after 2010 – not full deflation, but flirting with it. Remember all those zero-hour contracts? Not exactly the career stability your parents had!

4. The Central Bank's Nightmare

Normally, when the economy's in trouble, the Bank of England cuts interest rates to encourage spending. But what happens when rates hit zero and deflation is still going strong?

It's like trying to accelerate a car that's already flooring it. You can't push the pedal any further!

This happened to Japan, the Eurozone, and even the UK after the financial crisis – interest rates hit rock bottom, and central banks had to get creative with things like quantitative easing (basically printing money and hoping for the best).

The Phillips Curve: The Economic "Choose Your Fighter"

For my HL students wondering how inflation and unemployment relate – this is where the Phillips Curve comes in. It's basically the economic version of those "you can only pick two" memes.

The Short-Run Phillips Curve: The False Promise

In the short run, there seems to be a trade-off between unemployment and inflation. Want to reduce unemployment? Pump money into the economy and accept higher inflation. Want lower inflation? Tighten monetary policy but watch unemployment rise.

It's like those fitness influencers promising you can eat whatever you want AND get abs – seems too good to be true, and it is!

Real-world example: In the 1960s, UK policymakers thought they could permanently lower unemployment by accepting a bit more inflation. They pumped money into the economy, and for a while, it worked! Unemployment fell and inflation rose a bit. Everyone was chuffed. Then the 1970s happened, and suddenly we had both high inflation AND high unemployment. Oops.

The Long-Run Phillips Curve: Reality Hits Hard

Economists eventually realized that this trade-off only works temporarily. In the long run, the Phillips Curve is vertical at something called the "natural rate of unemployment."

What does this mean in English? You can't trick the economy forever. Eventually, people catch on to inflation and demand higher wages, bringing unemployment back to its natural rate but with higher inflation to boot.

It's like when you keep hitting the snooze button – you might get 10 more minutes of sleep, but eventually you'll still have to get up, and now you're late!

So Which Is Worse: Unemployment or Inflation?

The million-pound question! Should governments prioritise fighting unemployment or keeping inflation low?

The answer is... it depends (classic economics cop-out, I know).

When Fighting Inflation Takes Priority:

If you're Venezuela with 2,720% inflation in 2021, it's pretty obvious that controlling inflation comes first. When your morning coffee costs twice as much by lunchtime, employment becomes a secondary concern!

The UK had its own inflation crisis in the 1970s, hitting over 25% in 1975. Everything from bread to petrol doubled in price within a few years. The government eventually prioritised inflation-fighting over jobs, and unemployment soared in the early 1980s as a result.

When Fighting Unemployment Takes Priority:

During COVID-19, governments worldwide basically said, "Inflation who? We don't know her." They poured unprecedented amounts of money into their economies through furlough schemes and business support.

The UK government borrowed about £300 billion in 2020-21 alone – the highest peacetime borrowing ever. This kept unemployment relatively low during the pandemic but contributed to the inflation we're seeing now.

The Bottom Line: Deflation Is (Usually) the Worse Evil

While both high inflation and high unemployment are bad news, most economists agree that deflation is particularly nasty because:

1. It's harder to fix (you can't lower interest rates below zero... well, not easily)

2. It creates a self-reinforcing cycle of economic decline

3. It increases debt burdens when people are already struggling

4. It can last for decades (just ask Japan)

As former US Federal Reserve Chair Ben Bernanke once said, "Deflation is in many ways worse than inflation; it's harder to fight with conventional monetary policy."

How to Smash Deflation Questions in Your IB Exams

When you're tackling those deflation questions, remember:

• Always distinguish between benign and malign deflation

• Explain the deflationary spiral: falling prices → delayed purchases → falling business revenue → job cuts → less income → even less spending → more falling prices

• Link to relevant examples (Japan's Lost Decades, post-2008 financial crisis in Europe)

• For HL students, connect to the Phillips Curve and explain why the long-run trade-off doesn't actually exist

For data response questions, keep an eye out for economies with prolonged low inflation near zero (like the Eurozone in the 2010s) and analyse whether they were at risk of tipping into deflation.

The Final Thought: Price Stability Is the Goldilocks Zone

The ideal isn't high inflation OR deflation – it's price stability, with modest inflation around 2%. It's like porridge that's not too hot, not too cold, but just right.

Next time you see prices dropping everywhere, don't just celebrate your cheaper shopping – check if unemployment is rising too. It might be that those bargains come with a hidden cost that's much higher than any discount!

Stay well, unlike deflation, your IB Economics grade can definitely go up if you put in the work!