Inflation has many costs, such as menu cost, distortion on market economy/relative prices, unfair tax treatment...

Inflation has many costs, such as menu cost, distortion on market economy/relative prices, unfair tax treatment on capital gains and interest income. Even though, economists commonly believe deflation may be worse. Why is that?

Expert Solution

Answer: Inflation is usually referred to the situation when the price level generally increases over time and the opposite situation is described by deflation. During the period of deflation, price level falls substantially, now fall in the price level means higher purchasing power, means consumers can now purchase higher amount of goods and services. But the problem arises due to the fact that the consumers expect that the future price level will be lower than the present price level which means that in the present period they don't spend much because of their expectation of future price level. Now the suppliers of goods and services face the situation of excess supply and to sell those goods and services, they keep on lowering the prices of those goods and services. Hence they face losses and to compensate the loss they reduce the number of workers and as a result of which level of unemployment in the economy rises. This means that recessionary situation arises which slowers economic growth. Also because people hoard money because they expect that the price level will fall further, the level of investment in the economy falls which means that the interest rate keeps on falling and eventually reaches at zero level and this situation refers to as the liquidity trap. And in this situation, monetary policy becomes completely ineffective and the economy witnesses a period of overall slowdown . Hence, even though inflation has detrimental effects, but deflation is even worse than that.

Rahul Sunny answered 1 year ago

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