Deflation is when prices keep going down. This might sound like a good thing at first, but it can have a detrimental effect on jobs and wages.
To buy or not to buy?
What would you do if you knew the £100 bike you wanted to buy today was going to be reduced to £90 tomorrow? You would probably wait to buy it for the cheaper price. When prices begin to fall, people expect they will continue to go down. This expectation means people spend less today, in hope of buying at a cheaper price tomorrow. But this is bad for businesses.
If prices fall, businesses will probably make less profit. They do not like to see their profits go down, so they will try to do something about it. Let’s go back to that bike you wanted to buy. The owner of the shop is now getting £10 less for each bike and so may try to cut costs to make up for this loss.
This is where deflation can negatively affect employees. Businesses’ biggest cost is usually staff. To reduce staff costs, employers have two options: cut wages or cut staff. In other words, deflation could lead to you losing your job or getting paid less.
If prices fall on a large scale, there may be many job losses. People typically spend less when their incomes fall, so they might not be able to afford the bike at £90. So now, that business could be forced to cut prices further to sell anything at all. This creates a downward spiral as prices need to be reduced again. As their incomes continue to fall, businesses can no longer afford to keep workers, unemployment becomes more widespread, so people can’t buy as much and so on…
This spiral of falling prices and unemployment is often associated with a recession.
When prices fall does my debt go down too?
No.
Many people have some sort of debt, eg a mortgage, a student loan or a credit card. Deflation can make it more expensive to repay your debts because, regardless of the general prices for goods and services, the amount of money you owe remains the same.
If you borrow £100 to buy your bike today but prices fall, you will still owe £100 tomorrow. This means you are effectively spending more for the bike than it is now worth.
Now, say you bought a house and its value dropped by £10,000 but you are still paying off the mortgage. Even though the house isn’t worth its original price, you still must pay the same amount. This is bad news when you think about all the other things you could have spent that £10,000 on.
How do we avoid deflation?
The Government has set a target of 2% inflation and it is the Bank of England’s job to ensure it stays at that level.
Our 2% target is similar to that of many other countries. It is low enough to keep price rises small but high enough to stop them falling too much or too quickly.
So, should I be worried whenever I see reduced prices?
Not necessarily.
There is nothing wrong with occasional offers and discounts. Sometimes businesses will do this strategically to attract new customers, or to sell off old stock before releasing new products. It is not always a sign that demand is low or that firms are struggling to make money.
There are also plenty of examples where prices fall as technology advances – imagine how much a computer would have been worth 50 years ago, when almost no one else had one.
