Question

Identify and analyze macroeconomics consequences of deflation and thoroughly explain how it reflects fundamental principles of macroeconomics.

Answer 1

Deflation refers the situation where change in price in one period is lower than of previous period, the CPI has declined, indicating that the economy is experiencing inflation. It can have severe negative effects on growth and economic stability. It usually occurs in and after periods of economic crisis and lead to decrease in demand for consumption and investment. This leads to overall decline in asset prices as producers are forced to liquidate inventories that people no longer want to buy. As more money is saved and less money is spent this leads to further decline in aggregate demand. At this point people expectations about future inflation are lowered and they begin to hoard money.

As production slows down to accomodate the lower demand, companies reduce their workforce increasing unemployment and these unemployed people are most likely to default on their debts. As bank's balance sheet becomes shakier, depositors seeks to withdraw their cash as the chances of failure of bank have increased. Central bank and govt adopt various expansionary monetary and fiscal policies to expand the demand, by lowering the interest rate and increasing the public expenditure.