Question

In: Economics

Inflation has traditionally been a concern of the Federal Reserve. Recently, there has been the possibility...

Inflation has traditionally been a concern of the Federal Reserve. Recently, there has been the possibility of deflation. Should the Fed be concerned with deflation of prices? What about targeting 'nominal GDP'?

Solutions

Expert Solution

Deflation is the fall in the price of commodities. It is not a problem for the economy as value of money increases due to deflation but it results in high unemployment so Fed wants to overcome whether there is inflation or deflation. Fed can correct deflation by increasing the money supply of an economy by using its various tools i.e. purchase of government securities, decrease in reserve requirement, etc.

Nominal GDP = Real GDP X Price Level

Decrease in price level decreases the nominal gdp of the country. When Fed take into account the price level and increases money supply then, nominal GDP will also get corrected.

Deflation can occur without recession because deflation is just fall in the prices of goods and services. On the other hand, recession is the economic slowdown or negative growth rate.

Yes, deflation can be beneficial because of following reasons:

1. Due to deflation, the price of goods decreases which leads to lower expenditure of the public and as a result, budget of people reduces.

2. Deflation makes loan easier for people as interest rate at the time of deflation is less.

3. Deflation hurts rich people as value of property decreases at the time of deflation and rich people hold more assets as compared to poor people.

Deflation worsen recession because at the time of recession there is economic slowdown and many people loose their job and if after that deflation occurs then value of money increases which further force the firms to hire less worker. As a result, unemployment further increases.

Federal Reserve can use open market operation, reserve requirement, etc to increase the supply of money which helps in correcting the problem of deflation.


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