Deflation means a prolonged period of falling prices. Deflation has the following negative consequences:
- Businesses and consumers are aware that prices are falling and thus delay purchases of goods and services as much as possible. This reduces demand in the economy and leads to less production, less jobs, less cash flow for businesses and individuals.
- Real interest rates are equal to => nominal rate – inflation rate. If the inflation rate is negative, real rates of interest can actual get higher as deflation continues. Since nominal interest rates cannot got below zero it means the central bank cannot stimulate the economy through lower interest rates. If deflation persists, higher real interest rates make it credit less affordable which reduces economic activity and demand in the economy.
- Debt is services out of nominal cash flows. If prices are falling, so are sales and from the government’s perspective, tax receipts. Debt payments are however fixed. That means that debt servicing as % of cash flow rises. This combined with less demands leads to more bankruptcies which in turn lead to layoffs and reduced demand.
