Why Some Inflation is Better
Than Deflation
Some Benefits of Low Inflation:
Inflation causes real interest rates to be lower than
nominal interest rates. When businesses make decisions
about borrowing, they consider real interest rates. When
an economy is facing slow growth, zero nominal interest
rates are the limit on how low the Federal Reserve can set
interest rates. But with inflation, real interest rates can
even be negative and may stimulate borrowing and
spending.
Inflation lowers the burden of debt that an individual,
business or country may have. Debt is being paid back
with dollars that have less purchasing power (adjusted
for inflation, the real or effective interest rate is lowered
by the rate of inflation).
What’s Harmful about Deflation?
Deflation results in real interest rates being higher than
nominal interest rates. This occurs because loans are
being repaid with dollars that have more purchasing
power.
Nominal Interest Rates + Deflation = Real Interest Rates
Deflation increases the debt burden of an individual,
business or country.
Deflation makes Monetary Policy Ineffective
Deflation creeps into an economy that is experiencing
very slow growth over a long period of time. Interest
rates in such and economy will therefore already be zero
bound, much as they currently are in the Euro Area. But
deflation causes real interest rates to be higher; this
works against the desired expansionary policy of the
country’s Central Bank and makes their policy virtually
ineffective.
Deflationary Cycle
Deflation can also cause a deflationary cycle. It
starts when businesses lower prices because
demand is low and they haven’t been able to sell
their goods. But as prices are lowered, instead of
buying, consumers put off their purchases because
they expect prices to go even lower. When this
happens, businesses lower their prices again and a
deflationary cycle (which is very difficult to come
out of) has begun.