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Deflation and the Economy

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What are some of the damaging effects deflation has on an economy? What would be a monetary policy prescription to reduce or eliminate deflation? How would deflation affect your business or a business you are familiar with?

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Solution Summary

The solution discusses the disastrous effects of deflation on the economy and what monetary policy can be implemented to address the problem.

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What are some of the damaging effects deflation has on an economy?
Note: You can utilize the work of Brooks and Quising (2002) entitled "Dangers of Deflation" and Ryu (2003) entitled "How Real is the Threat of Deflation to the Banking Industry?".

Deflation may arise if consumers reduce their spending because they expect prices to continue to fall or as they become more concerned about their future economic security, particularly if unemployment is rising (Brooks and Quising, 2002).

Damaging effect of Deflation:

Deflation can reinforce the fall in output and demand (Brooks and Quising, 2002)
"When broad and deep episodes of price decline follow severe contractions in aggregate demand, or come from competition in industries with excess capacity resulting from over-investment, deflation can reinforce the fall in output and demand".
"Declining prices can lead to shrinking profit margins, business failures, and resulting unemployment, which reduces purchasing power further, so prices, output, and demand continue to spiral downward".

Deflation increases the real value of debt (Ryu, 2003):
"Deflation increases the real value of debt while decreasing the value of collateral for loans. The resulting deterioration in the corporate and household balance sheets, combined with a higher real interest rate, tends to weaken loan demand and could lead to a sharp increase in loan losses. As a result, deflation would have significant adverse effects on the banking industry, ...

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