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

It is first necessary to define deflation. Deflation is a reduction in the general level of prices in an economy. It can be measured by indices such as the Consumer Price Index (CPI) which takes the price of an 'average' basket of goods, a fall in the price of this 'average basket' would equate to deflation. A supply-side policy such a subsidy for research and development in the manufacturing industry could cause deflation in an economy. A subsidy for R+D would cause firms to invest more heavily to produce more productive techniques for manufacturing. AS a result output per worker should increase, meaning that fewer workers will be needed to create the same output. This can be seen in the diagram in the outward shift of SRAS (see diagrams). This leads to a lower cost per output. This lower cost is passed onto consumers in the form of lower prices. This will lead to cost-pull deflation, as seen in the fall in price-level from PL1 to PL2, this is deflation that is independent of demand. This deflation can be described as benign as it is due to an increase in productivity which would be beneficial to the economy in the long run.