Question

most developing countries such as South Africa, Zambia, Tanzania, Mozambique, Nigeria etc, are battling to contain inflation at a desirable levels. on the other hand, some developed economies are battling with deflation. using relevant macroeconomic theories to support your arguments:

a) write a detailed review of the challenges posed by deflation within an economy. your answer should cover all sectors including the business, government and the society as well as other macroeconomic indicators ( GDP, unemployment, interest rate etc.) ( 25 marks)

Answer 1

A.

A deflation is a phenomenon, where the price level decreases. It means that deflation is negative of inflation. As a result, the deflation causes purchasing power of money to increase. Hence, real value of money increases. due to this reason, deflation poses different challenges. The first challenge is that deflation and the resulting increase in real value of money, causes people to spend less and save more. It reduces the AD in the economy and AD curve shifts to the left. It reduces the GDP level and economy contracts. It leads to the factories laying off the workers and unemployment rate increases. The second challenge is the adverse impact on employment causes a further increase in deflation and negative chain of activities starts. As per the Phillips curve, there is an inverse relation between unemployment rate and inflation. So, a higher level of unemployment, leads to decrease in inflation or rise in deflation. The third challenge is the increase in imports and decrease in exports of the country, further negatively affecting the GDP. When real value of money increases, the Forex rate of the domestic currency appreciates. It makes exports to be expensive and imports to be cheaper. As a result, exporters of the nation, feel disadvantageous in the international market. It hurts the economy. It is the problem regularly faced by Japan whose export oriented economy faces deflation. The fourth challenges is the rock bottom interest rate in the economy. It happens as savings reach to the market of loanable funds and supply of these funds shifts to the right. It cause interest rate to decrease. But, it can create the problem of liquidity trap, where banks are willing to lend, but households and firms are not interested to borrow. It happens because real value of money is high due to inflation.

So, above challenges create problems for the government in framing policies to counter the deflation, as people do not want to spend money. So, fiscal policies are also less effective, because marginal propensity to consume lowers and value of multiplier decreases. It makes household to save more of any income or benefits are offered to them. Businesses are less interested to invest as demand in the economy is poor. Hence, deflation makes different players of the economy to suffer and it is considered as a bigger problem than the inflation.