(a) What is deflation? (b) Outline any three positive effects of deflation. (c) Explain the ways by which inflation affects any three functions of money.

Answer Details

(a) Meaning of deflation. Deflation is a sustained fall in the general price level of goods and services in an economy over a period of time. It is the opposite of inflation, and it usually means that the purchasing power of money is rising while the volume of money in active circulation, output, or demand is falling.

(b) Three positive effects of deflation.

1. Higher purchasing power of money. As prices fall, the same amount of money buys more goods and services, so real income and the standard of living of people on fixed incomes improve.
2. Encouragement of saving. Because the value of money rises over time, holding money becomes rewarding, so people are encouraged to save.
3. Redistribution in favour of creditors and fixed-income earners. Lenders, pensioners, and salary earners gain because the money they receive later is worth more than when the debt was contracted or the salary was fixed.

(Other acceptable points include cheaper exports if domestic prices fall relative to foreign prices, and reduced cost of living.)

(c) How inflation affects three functions of money. Inflation is a persistent rise in the general price level, so it erodes the value of money and disturbs the jobs money is meant to do.

• Medium of exchange. When inflation is severe, people lose confidence in money and become unwilling to accept it in exchange for goods. Trade may drift back towards barter or towards foreign currency, so money performs the exchange function poorly.
• Store of value. Money kept as savings loses value as prices rise, so it can no longer store purchasing power over time. People switch to holding goods, land, or foreign currency instead.
• Standard of deferred payment. Because the real value of money falls, lenders are repaid in money worth less than they lent, so credit and long-term contracts become risky and lending is discouraged. (Inflation also weakens the unit of account function, since constantly changing prices make money an unreliable measuring rod of value.)

Examination takeaway: tie each effect back to the change in the value of money, since that is the single idea the examiner is testing across all three functions.