Why do we fear deflation more than inflation?

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justaguide's profile pic

justaguide | College Teacher | (Level 2) Distinguished Educator

Posted on

It may seem counter-intuitive but inflation or an increase in prices, or a decrease in the value of the currency, is something that is beneficial for the economy. Though one could not argue in favor of the kind of inflation in Zimbabwe, a moderate inflation of 3-4% is what the aim of economic policy should be.

There are several reasons why the moderate level of inflation is required. One is them is that deflation means an increase in the value of money. So people are less likely to spend now; they keep the money with themselves as it would be possible to buy more with the same money in the future. This decreases the present demand for goods and in turn leads to further deflation. A low demand implies that supply too has to be reduced.

The second is deflation discourages people from borrowing money. This follows from the fact that the repayment for the funds that they borrow now would later be with money that has a higher value than what they have borrowed.

A third is a deflationary scenario increases unemployment as there is not enough demand to warrant an increase in supply; owners of business are averse to borrowing funds to increase capacity and employment opportunities; and the logically sound decrease in wages which is expected to happen does not due to what is known as downward nominal wage rigidity.

These are some of the reasons why inflation should be allowed to remain at a moderate level for healthy economic growth.

pohnpei397's profile pic

pohnpei397 | College Teacher | (Level 3) Distinguished Educator

Posted on

It is not always true that we fear deflation more than inflation.  There are times when deflation is more of a threat (modern Japan, for example) and times when inflation is more of a threat (Weimar Germany; various developing countries).  A country's circumstances often determine which is a bigger threat.

If we do fear deflation more than inflation it is because deflation is always a sign of a weak economy whereas inflation may be caused by an economy that is too strong.  Deflation tends to be caused by a collapse in demand.  This is never a good thing.  Inflation, by contrast, may be caused by excessive aggregate demand which often means that an economy is growing too quickly.

Therefore, it is not that the effects of deflation are any worse than the effects of inflation.  Rather, deflation is always a symptom of economic weakness while inflation may at times be an indication of growth.

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