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ACCA Applied Knowledge · Business and Technology · Macroeconomic factors

An economy experiences a prolonged fall in the general price level. Consumers delay purchases expecting lower prices later, and firms cut output and jobs. Which statement best explains why deflation of this kind is harmful?

Prolonged deflation is harmful because it raises the real burden of debt and encourages consumers to delay spending. Lower demand leads firms to cut output and jobs, which can push prices down further in a downward spiral. Export gains do not always offset this.

  1. AIt increases the real burden of debt and can create a downward spiral of falling spending and outputCorrect
  2. BIt raises the real value of debt for lenders only, with no wider effect on output or employment
  3. CIt always increases exports because domestic prices fall, offsetting any loss of domestic demand

Explanation

Falling prices raise the real value of debt, and delayed spending reduces demand, output and employment, which can reinforce further price falls. The second option ignores the wider economic effects, and the third wrongly claims that export gains always offset lost domestic demand.

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