Question

Why is deflation bad?

Answer 1

Deflation

When there is a negative changes in prices, it is called as Deflation. Inflation rates are evaluated with the help of Consumer Price Index (CPI) in the U.S. The CPI Index declines when the change in prices in one period is lower than in the previous period, this clearly shows that there is deflation in the economy.

Deflation is considered to be bad for the economy due to :-

• A general decrease in price is a good thing as it gives the consumers greater purchasing power. This is only when the price drop is moderate and in certain products only, but if the fall in prices is persistent it can have severe negative effects on the growth and economic stability.
• Whenever, the economy faces period of economic crisis, recession or depression, economic output slows as demand for consumption and investment drops. This situation further aggravates the economic conditoion as already a bad condition will go towards worse.
• In this siutation the producers are forced to liquidate inventories that people no longer want to buy. As the prices begin to fall, consumers and producers begin to hold on to the liquid moneyreserves and as more money is saved, less money is spent, it further decreases the aggregate demand.
• Due to the situation of deflation, people start spending less and this creates the problem of hoarding. slowly it spreads to all areas in the economy.
• As the demand decreases in deflation, the production slows down and because of this many companies reduce their workforce and this creates the problem of unemployment. During recession, the workers find it even more difficult to find new job and this results in defaulting in their loans.
• The increasing bad debts makes the situation even worse for the financial sector as they have to write them off as losses.
• Due to fear, people start to redeem their deposits , due to the increase in redemption the banks can no longer meet its own obligation. And this leads to financial instituitons' collapse.
• If a deflation situation sets in after the economic downturn, it causes even deeper and more severe crisis.

Thus, it is a dangerous situation for any country's economy in a deflationary period, therefore, deflation is bad.