Wednesday, February 18, 2009

UK Deflation?


Usually a fall in inflation is seen as good news. It enables lower interest rates, more competitive exports and more competitive prices for consumers.

The problem is that with interest rates already at 1%, there is little enthusiasm to see lower rates in the economy as many feel it would have limited effect at best.
  • There is also the prospect of deflation - a negative inflation rate.
  • RPI stands at 0.1% This reflects the large fall in interest rates and mortgage interest payments. The CPI gives a better indication of 'underlying inflation
  • See: Difference between CPI, RPI, RPIX inflation
  • The government set an inflation target of 2% rather than 0%. They are concerned that very low or negative inflation will lead to sluggish growth.

Why are Falling prices bad for the economy?

If lower prices are caused by improved technology and lower costs of production this is not bad but beneficial. However, if they are resulting from sluggish demand it has various problems
  1. If prices are falling people delay purchasing goods, especially expensive ones like cars, tvs. This causes lower growth
  2. Real Value of debt increases. Deflation means it is harder to pay off your debts. With many people indebted in the UK, this will reduce their spending and disposable income.
  3. This is exacerbated because when people took loans, mortages out they had an expectation of inflation. If this inflation fails to materialise the loan will be much more expensive than they expected.
  4. Real Wages become too high. Workers tend to resist nominal wage cuts. If prices are falling, real wages will rise. This could cause real wage unemployment and firms are more likely to lay off workers.
Falling prices may benefit those who like to keep their gold coins under their mattresses, but deflation is often seen as an important signal of a real depression rather than just a minor recession.

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