Falling Prices

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.

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.

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.

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.

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.

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?

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.

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 Statistics^1,2

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.