Explain the possible causes of deflation in an economy. (15)

Deflation is defined as the fall in the general price level of an economy. It is negative inflation. It is usually calculated using the consumer price index (CPI) which measures changes in the price level of a basket of consumer goods and services purchased by households. The UK's current inflation rate is 2.6% as of April. One possible cause of deflation in an economy is supply side policies, such as subsidies for research and development. These cause deflationary pressure because they can lead to production techniques which increase output per worker, such as automation, which then means that fewer workers are needed to produce the same amount of goods therefore average unit cost can be reduced. This therefore leads to lower prices for consumers as a shift out in supply reduces cost push inflationary pressure. The diagram below shows how the shift out in the supply curve causes a fall in the general price level from P to P1. (Standard labeled diagram showing shift out of the supply curve) Another cause of deflation is lack of demand in an economy. This could be caused by, for example, low investment due to uncertainty related to Brexit. As investment is a component of aggregate demand, a fall in investment due to poor investor confidence would cause a reduction in AD, which would then lead to a shift inwards of the AD curve, reducing demand pull inflation and potentially causing deflation as shown in the diagram below, where the price level has fallen from P to P1. (Standard labeled diagram showing shift in of the demand curve.)