Question

Deflation refers to the phenomenon of a negative inflation rate. (In 2004, the inflation rate was negative in Hong Kong and we say Hong Kong suffered deflation in 2004.) Many people regard deflation as bad. Can you explain why? Is deflation sometimes good (at least for some people)? (6%)

Q2

People complained about ‘negative real interest rates’ in the early 1990s, and again since 2009. Can real interest rates be negative? How can that be so? (4%)

Answer 1

Answer to Question 1)

Deflation takes place in any economy, when the general price level of goods and services continues to decline over the years. This is also known as a drop in the Aggregate Demand which is the total demand for goods and services in the economy. The Gross Domestic Product or the total goods produced in the country also begin to decline in value and overall output.

Therefore, the core reason why people call deflation to be bad for the economy is because it creates a negative market situation and is cyclical and cannot be resolved without government support which may change the tax rates or increase investments to induce demand in the economy. Another option is to alter the interest rates which commercial banks charge and decrease the same so that demand can again take place.

The end result of such deflation is that people demand lesser and therefore, the producers start making substantial losses. Due to the loss’s jobs are lost and payments to the labour force is cut which further reduces demand and this cycle is why people consider it to be bad for the economy.

One party which gains from a deflation are those people, which give away loans i.e. lenders. The lenders charge an interest on the amount lent and due to inflation, the overall return increases.

For example, if you give a loan of 10$ at an interest rate of 5% annual, then at the end of the year you are to get 15$ from the same. These 15$ however have increased in value and can now purchase more goods than 15$ could a year ago. Therefore, the real rate of return gets added by the deflationary %. For example, if in this case deflation is 7% then the actual return is 7+5=12% instead of 5%

Answer to Question 2)

Negative Interest Rates happen, when the deflation is too high in the economy. When a recession takes place, consumers as well as producers hoard money in banks or otherwise and this leads to low demand and supply in the economy. To counter this, it is encouraged that interest rates should be negative meaning that people need to pay banks whenever they deposit money

This is used to encourage people to spend more money in the economy and is counteractive to the above-mentioned deflation pressure.

Realistically this was followed in countries such as Japan and Switzerland to boost economic growth and to ensure that people spend money instead of saving the same.

Please feel free to ask your doubts in the comments section.