Question

What problems does deflation cause?

Short answer

Deflation can cause significant issues such as decreased consumer spending due to anticipated lower prices, increased real value of debt making repayments costly, and stagnation of economic growth due to reduced investment by businesses due to low revenue from sales.

Step-by-step solution

Define Deflation

Deflation is a decrease in the general price level of goods and services typically associated with a contraction in the supply of money and credit in the economy. During deflation, the purchasing power of currency rises over time.

Problem 1: Decreased Consumer Spending

When people expect that goods and services will be cheaper tomorrow than they are today due to deflation, they might delay their spending. This decrease in consumer spending can lead to a decrease in business revenue, which can then lead to layoffs and a surge in unemployment rates.

Problem 2: Debt Increase

The real value of debt increases during deflation, as the value of currency increases. For borrowers, repayments can become more costly, and for lenders, there's an increased risk of defaults on loans.

Problem 3: Stagnation of Economic Growth

As a result of reduced consumer spending and costly debt repayments, businesses may reduce investment in operations and expansion. This lack of investment can lead to stagnation in economic growth.

Key concepts

Consumer Spending

During periods of deflation, consumer spending often decreases significantly. When prices of goods and services fall, people anticipate even lower prices in the future. As a result, they might postpone buying products to take advantage of expected future price drops.

This delay in spending can create a vicious cycle for businesses. Lower consumer spending means decreased business revenues, which might force companies to cut costs by laying off employees.

• Lower consumer spending reduces demand for products.
• Reduced demand can lead to decreased production.
• Businesses may respond with layoffs, which increase unemployment rates.

High unemployment can then further discourage consumer spending, perpetuating the cycle.

Debt Increase

Deflation can lead to an increase in the real value of debt. This happens because while the nominal amount of debt remains constant, the purchasing power of money increases. Thus, the real cost of debt repayment becomes more burdensome for borrowers.

Borrowers may struggle to pay off their debts as their income might not rise correspondingly with deflation. Meanwhile, for lenders, the risk of borrowers defaulting on their loans increases.

• The cost of fixed debt increases in real terms.
• Borrowers may encounter difficulties meeting repayment obligations.
• Increased default risks affect lenders negatively.

This can further exacerbate economic turmoil as a higher number of defaults and bankruptcies occur.

Economic Growth

Deflation can lead to stagnation or even contraction in economic growth. When consumer spending declines and debt burdens rise, businesses may limit their investments. Without sufficient consumption to drive demand, companies hesitate to expand operations or invest in new projects.

This hesitance is primarily because the uncertainty caused by deflation and a cautious market environment makes expansion risky.

• Reduced consumer demand curtails business growth opportunities.
• Investment in expansion becomes risky and unattractive.
• Stagnant growth can lead to broader economic challenges.

Therefore, deflationary periods often see stalled economic progress, as the ripple effects of reduced spending and rising debts hinder recovery and growth.