Discuss whether the MPC should be concerned about the risk of deflation in the UK economy

Edexcel AS Economics Paper 2 June 2016 Extract

With reference to Extracts A and B and your own knowledge, discuss whether the MPC should be concerned about the risk of deflation in the UK economy. (15 marks)

Paragraph 1

1. One reason the MPC should be concerned about deflation is that it can very easily trigger a deflationary spiral, which is damaging to the UK's macroeconomic performance.
2. Deflation is when there is a fall in the average price level.
3. When deflation first occurs, consumers form an expectation that prices will continue to decrease in the future.
4. Extract A Line 6 also mentions that inflation rates are 'expected to be negative'.
5. This means that they are likely to delay spending on big purchases, such as homes.
6. This leads to a fall in consumer spending, and a fall in aggregate demand in the economy.
7. This leads to further rounds of deflation and also an increase in unemployment due to a lack of demand for goods and services.
8. In 2015, the EU also experienced deflation with a rate of -0.5%, and inflation rates in the UK also fell to around 0.5% in October 2024.
9. Extract B mentioned the example that Japan averaged an inflation rate of -0.3% across 12 years, as they were stuck in a deflationary spiral.

Evaluation 1

1. However, UK inflation rates remained positive as of January 2015, which means there is currently disinflation but not deflation.
2. Disinflation is when the rate of inflation falls but remains positive.
3. Also, Extract A Line 8 mentions 'Britain's economic recovery'.
4. This suggests that the MPC are aware that inflation is falling but they expect it to recover along with the economic cycle.
5. The initial cause of the fall in inflation rate seemed to be lower oil prices, but as aggregate demand increases along with the economic recovery, price level should begin to rise again, without the need for lower interest rates, which are already close to 0%.

Paragraph 2

1. Another reason why the MPC should be concerned about deflation is due to the difficulty of correcting it.
2. Extract A Line 6 also mentions that inflation rates are 'expected to be negative'.
3. As inflation falls too low, the first response is often for the MPC to reduce interest rates, as this would lead to a lower cost of borrowing and therefore incentivise consumers and businesses to spend.
4. The extract however also mentions that interest rates are already close to 0.5% which means that there isn't much room to reduce interest rates further.
5. This means that they may have to rely on the government to use expansionary fiscal policy which is not ideal especially given that there is an aim to control the level of national debt in the economy.

Evaluation 2

1. However, in case inflation gets even lower, the Bank of England can introduce quantitative easing.
2. This is when the central bank create money electronically and use it to buy assets from high street banks.
3. This gives them a boost in liquidity which should incentivise them to offer lower high street interest rates to consumers and businesses.

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