How would you feel if tomorrow, the price of all goods and services went down? Sounds pretty good, right? While it does sound great, continually falling prices can actually present problems for the economy itself. This might seem paradoxical given how good it may feel to pay a lower price for goods. After all, how could a lower car payment be so bad? If you're curious about how this phenomenon is actually harmful to the economy, then read on!
Price Falling Definition
Let's begin our analysis by defining falling prices. Falling Prices can be defined as the general decrease in prices in the economy. This will commonly occur with deflation since deflation requires the price level to fall. Falling prices will happen for a multitude of reasons, including supply and demand factors, but the general idea is that prices will decrease in the economy.
Falling prices occur when there is a general decrease in prices in the economy.
Deflation occurs when the price level falls.
The antithesis to falling prices would be rising prices. Rising prices can be defined as the general increase in prices in the economy. This will commonly occur with inflation since inflation requires the price level to rise. Similarly to falling prices, rising prices will occur for many reasons, but to delineate between the two requires seeing the trend in prices.
Rising prices occur when there is a general increase in the prices in the economy.
Inflation occurs when the price level rises.
Want to learn more about inflation and deflation?Check out our articles:
- Inflation
- Deflation
Causes of Falling Prices
What are the causes of falling prices? Let's go over them here! There is a glut of reasons for falling prices in the economy. We will go over what causes falling prices in the short run and long run.
Causes of Falling Prices in The Short Run
In the short run, falling prices will usually be caused by fluctuations in the business cycle. The business cycle is a series of expansions and contractions in the economy. When the economy is contracting, deflation will tend to occur, and as a result, falling prices will be present. In contrast, when the economy is expanding, inflation will tend to occur, and as a result, rising prices will be present.
Causes of Falling Prices in The Long Run
In the long run, falling prices will usually be caused by the money supply in the economy. The institution that typically controls the money supply is the central bank. In the United States, this is the Federal Reserve. If the Federal Reserve implements a contractionary monetary policy, then the money supply in the economy will decrease, which leads to a decrease in demand, which will lead to a decrease in the overall price level. In contrast, if the Federal Reserve implements an expansionary monetary policy, then the money supply will increase, which leads to an increase in demand, which will lead to an increase in the overall price level.
You can learn more about monetary policy in our article: Monetary Policy.
Causes of Falling Prices: Misconception
A common misconception regarding the cause of falling prices revolves around supply and demand. Many believe that falling prices are merely a result of supply and demand issues. While this is true for certain goods relative to others, this will seldom be true for the price of all goods and services in the economy.
For example, let's say that there is a decrease in prices for apples because of a supply issue. Producers of apples overestimated how many apples consumers needed and produced far too much. So much so that people are not buying some of their apples in the grocery store. This will cause the producer to lower their prices so that consumers will be incentivized to purchase the overabundance of apples in the market. While this does explain the lower price of apples when compared to, say, bananas, this does not cause the price of all goods and services to decrease in the economy.
Price Falling Examples
Let's go over an example of a price falling. To do so, we will look at falling prices in the short run and the long run.
Price Falling Example in the Short Run
In the short run, falling prices will occur due to fluctuations in the business cycle.
For example, let's say that the United States is going through a contractionary period in the economy. What is the result of this? During contractions, people are unemployed and have difficulty finding a job. This will cause people to purchase fewer goods overall. When there is less demand for goods and services, this will drive prices downward, causing falling prices.
Fig. 1 - Business Cycle
What is shown in the graph above? Above is a graph of a business cycle. Anytime the curve is downward sloping, there is a contraction in the economy. At those points, there will be falling prices in the economy due to decreased demand. In contrast, anytime the curve is upward-sloping, there is an expansion in the economy. At those points, there will be rising prices in the economy due to increased demand.
Interested in learning more about business cycles? Learn more by reading our article: Business Cycle
Price Falling Example in the Long Run
In the long run, falling prices will occur due to the money supply. In the United States, the Federal Reserve is primarily in charge of the money supply. Therefore, it has a big influence on whether prices fall or rise in the economy.
For example, let's say that the Federal Reserve implements contractionary monetary policy in the United States — it raises the reserve requirement, raises the discount rate, and sells treasury bills. This will cause the interest rate to rise and the money supply to decrease in the economy. Now, demand will be lower for goods and services, which will drive prices downward, resulting in falling prices.
Falling Prices vs Consumer Spending
How are falling prices vs. consumer spending related? We can tackle this question by putting ourselves in the shoes of someone experiencing falling prices. Imagine this scenario: the economy is experiencing a contraction, and prices are falling ubiquitously in the economy. Recognizing this phenomenon, how would you react?
Initially, you might think that falling prices are something you want to happen. Heck, who wouldn't want a cheaper grocery bill? However, think about the fact that prices are continuously falling. If prices kept falling, would you really want to buy something now or wait until the prices get even cheaper?
For example, let's say you would like to buy a new video game that initially cost $70 but fell to $50 and is expected to keep falling. Would you want to buy it for $50? Or wait a little longer until it's $30 or $20? You'll likely keep waiting, but this is the danger of falling prices! Other consumers in the economy will have the same mindset as you, but then that means that most people are not buying goods in the economy since, in the future, their prices will keep falling. Therefore, we can say that falling prices in the economy will cause consumer spending to decrease.
Falling Prices vs The Economy
What is the relationship between falling prices vs. the economy? Recall that falling prices occur when there is a general decrease in prices in the economy. If prices are decreasing in the economy, how will the economy be affected?
If there are falling prices in the economy, then it will impede economic growth. If prices keep falling in the economy with no end in sight, then demand will decrease. Without knowing when falling prices will stop, consumers will be incentivized to hold on to their money so that it can increase in value. Think about it, if prices are falling and the money supply stays the same, then consumers' purchasing power will increase! Since this occurs, consumers will wait for prices to keep falling to purchase their goods.
Recall that GDP is the value of all final goods and services produced in the economy. Consumers' decision to hold on to their money is what will preclude economic growth. Without consumers buying products, producers need to adjust and supply less of them. If consumers buy less and producers make fewer products, then GDP growth will slow down.
Want to learn more about GDP? Check out this article:
- GDP
Rising Prices and Falling Earnings
Let's take a look at what recent data says about price changes and earnings in the United States economy.
Fig. 2 - The United States Rising Prices. Source: Economic Research Service and U.S. Bureau of Labor Statistics1,2
What does the chart above tell us? We can see on the X-axis the following: food at home, food away from home, and earnings. Earnings are rather self-explanatory, but the food at home and food away from home need some context. Food away from home refers to restaurant prices, and food at home refers to grocery prices. As we can see, the prices for both have gone up from the previous year; an 8.0% increase for food away from home and 13.5% for food at home, respectively. However, earnings from the previous year fell by 3.2%.
Economic theory suggests that as earnings go down, prices should come down as well. However, the chart shows the opposite — prices are going up while earnings are going down. Why might that be? All theory is not perfect, and the real world may result in different outcomes. Consumers and producers will not always act in the way economic theory says they will. This is the case with the current situation of increasing prices and decreasing earnings.
Falling Prices - Key takeaways
- Falling prices occur when there is a general decrease in prices in the economy.
- Deflation occurs when the price level falls.
- The cause of falling prices, in the short run, is business fluctuations;the cause of falling prices, in the long run, is the money supply.
- Consumer spending will decrease with falling prices.
- GDP growth will slow down with falling prices.
References
- Economic Research Service, https://www.ers.usda.gov/data-products/food-price-outlook/summary-findings/#:~:text=The%20all%2Ditems%20Consumer%20Price,higher%20than%20in%20August%202021.
- Bureau of Labor Statistics, https://www.bls.gov/news.release/realer.nr0.htm#:~:text=From%20August%202021%20to%20August%202022%2C%20real%20average%20hourly%20earnings,weekly%20earnings%20over%20this%20period.
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