Tuesday, 12 October 2010

Why deflation is bad

Economists everywhere fear inflation and lots of effort is put in to keeping it down. Perhaps the most important tool for reducing inflation is increasing the interest rate in hopes of cooling down the economy. Often inflation is a result of a heated economy and a well-performing economy. Inflation is bad since it reduces the value of money, but the alternative is even worse for an economy. 

Now some large economies are facing deflation, Japan is already there, the USA is not far behind and the rest of the industrialised world may follow. Deflation means, opposite of inflation, that prices are falling over the entire market. This may at first sound like a good thing; things get cheaper we can increase our standard of living and so forth. However, if we all assume prices will be lower tomorrow than they are today; it will makes us curb spending. This will obviously decrease demand, which will lower prices even more and in the long run force companies to cut wages and lay off staff. If it goes this far, the downward spiral is in full spin. Furthermore, this will make debts more expensive as the money value increases. The trouble is now that lowering interest rates can only be done until they are 0, and even then the real interest rate is still positive. For Japan this is a real problem since the interest rate is currently extremely low.

Krugman on Deflation

Share on Facebook

No comments: