Question

To what extent should government be concerned about the prospects of deflation?

Answer 1

Deflation can be described as a reduction in the overall price level and can also be categorised as a negative inflation. When the overall price level in an economy is falling we assume that the economy suffering from deflation.

Policymakers especially the central bank of an economy have a greater role in not only targeting a particular level of inflation but also to take actions when it deviates from the level.

In case of deflation there are concerns over some serious macroeconomic problems that might creep in the long term. There is an expected decline in consumption spending when the prices are falling because consumers might be expecting further fall in the price level. Besides there are fears of higher unemployment and higher burden of real debt. When the rate of interest is held constant and there is a decrease in the price level there is a higher real interest rate. The debtors will have to pay a higher amount to the creditors because the real interest rate is increased. This will be very difficult for firms who borrow so that they can continue their production. There can be unwanted tightening in the monetary policy which will reduce the growth rate of the economy and create unemployment. We also realise that nominal wages are sticky so that when prices are falling real wages are increasing. Firms will hire few workers and therefore it will increase further unemployment. These are some concerns over deflation which suggest that deflation is not detrimental but can definitely bring stagnation to the economy if it is persistent for a long period of time.