How does deflation affect an economy?

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pohnpei397 eNotes educator| Certified Educator

Deflation, like inflation, can create winners and losers in an economy.

For example, lenders tend to win when there is deflation.  The money that they get back is actually worth more than the money they lent.  This helps them, but it hurts the people who borrowed the money.

Like inflation, deflation is bad for the economy when it is unpredictable.  When deflation is unpredictable, neither borrowers or lenders feel like they know what will happen to the price level.  Neither do producers or consumers.  This sort of uncertainty tends to lead to a drop in confidence and therefore to a drop in economic activity.

Finally, in a case like the current poor economic times in the US, deflation might make it hard to use monetary policy to stimulate the economy.  The central bank cannot lower interest rates enough to make investment look attractive and therefore cannot stimulate the economy in that way.