Monday, January 17, 2011

Deflation is Really Bad

One constantly here's about the dangers of inflation and constantly rising prices.  However, what about the opposite of inflation:  Deflation?  If inflation is bad, than it's antithesis should be good, right?  Well, not exactly.  While a decrease in prices is normally a good thing.  Check out the video below.

The video does a pretty good job of explaining one of the way that deflation can hurt the economy.  There's a couple more ways that deflation can wreak havoc on an economy.  One way is the additional burden it puts on those with any outstanding debt like on a mortgage, car, or student loan.  Paul Krugman summarizes it well.
even aside from expectations of future deflation, falling prices worsen the position of debtors, by increasing the real burden of their debts. Now, you might think this is a zero-sum affair, since creditors experience a corresponding gain. But as Irving Fisher pointed out long ago (pdf), debtors are likely to be forced to cut their spending when their debt burden rises, while creditors aren’t likely to increase their spending by the same amount. So deflation exerts a depressing effect on spending by raising debt burdens – which, as Fisher also points out, can lead to another kind of vicious circle, in which depressed spending because of rising real debt leads to further deflation.

The third way is the problem known as the Liquidity trap.  Since the most active way to fight a recession is by increasing the money supply, deflation poses a particular challenge.  Once the federal reserve lowers the interest rate to near zero, it has no further tools to stimulate the economy.  In deflation, the value of money grows even if it doesn't earn interest.  Therefore, even with near zero percent interest rate, there's no other monetary solution to try and get an economy going again.
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