Question

most developing countries such as South Africa, Zambia,Tanzania,Mozambique, Nigeria etc, are battling to contain inflation at a desirable levels. on the other hand, some developed economies are battling with deflation. using relevant macroeconomic theories to support your arguments:

a) write a detailed review of the challenges posed by deflation within an economy. your answer should cover all sectors including the business,government and the society as well as other macroeconomic indicators (GDP, unemployment, interest rate etc).

Answer 1

Persistent deflation, such as being faced in many developed economies around the globe, leads to deflationary gap. This is a situation in which, according to Keynesian economists, aggregate effective demand is less than the demand required to reach the potential output. In this situation, general price level in the economy is on the fall.

Due to fall in prices, there are various implications generated for the economy.

Business Houses- When prices go down, current profitability goes down. This also decreases expected rate of profit. As profit expectations go down, the busniess expectation tend to become bearish. There is very low inducement to invest in Production on the part of the capitalists. This reduces production in the next period, employment in the next period as well as income in the next period. Which further reduced the demand and which further leads to decrease in price in next periods and the cycle goes on. This is the vicious cycle in which low prices leads to low Production and employment and Income which further leads to low prices due to deficient demand caused by low income.

Society as a whole suffers because their Aggregate incomes go down. Gross domestic product of the nation also goes down. The standards of living go down. This is disastrous to the agricultural sector most. As price decrease, farmers are unable to get the prices they expect, sometimes not even enough to cover cost of production. This leads to rural distress.

Since income of the people go down, Governement's tax earnings also go down. Also, to remedy the situation, Governement has to use Expansionary fiscal policy where it reduces tax and Increases its spending. This leads to Huge government budget deficit and greater Debt to GDP ratio for the economy.

Since, there is General cut in production, there is reduction in employement period after period until policy to counter the situation is brought into force.

Now, since business expectation are not good about future profitability, there is lower investment demand and as a result, the interest rate lowers down as the supply of loanable funds is more than the demand of loanable funds. Monetary policy is used to counter deflation by infusing liquidity in the market which further reduces the interest rates.