Deflation – why is it a concern?

Here is a good video from DW on deflation. Deflation is seen as negative for an economy for the following reasons:

1. Money made today will be worth less tomorrow so investment is discouraged
2. Goods cheaper tomorrow reduces consumption and therefore aggregate demand
3. Central banks struggle to set real interest rates which are stimulatory
4. People who borrow money find that what they owe is worth more in real terms
5. Demand runs below the economy’s capacity to supply goods and services leaving an output gap. This can lead to unemployment and wage cuts which worsens the situation

One of the main problems at present is the fact that Central Banks are running out of ammunition – interest rate cuts – as rates are close to 0%. Therefore in order to stimulate demand they now have to use fiscal policy and more government spending would assist especially in areas that are in need – e.g. roads, bridges etc.

 

 

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