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If the economy suffers deflation, what will happen to the real interest rate? 

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If an economy suffers from deflation, the real interest rate will rise.  It will then likely become impossible for a central bank to lower the real interest rate low enough to prompt more people to borrow money.  This is one reason why deflation is something that economists fear.

Deflation can be defined as a drop in the overall price index.  This is the opposite of inflation.  When deflation occurs, goods and services in general become less expensive.  This sounds like a good thing because things get cheaper and consumers are able to buy more things with their paychecks.

Deflation is really not a good thing, though. One major reason why deflation is bad is that it increases the real interest rate.  Imagine that I borrow $1000 and have to pay 4% interest on that money.  At the end of the year, I must pay back $1040.  If deflation occurs, that $1040 is actually worth more than it was when I borrowed it.  For example, it might be worth as much as $1060 at the point when I borrowed the money.  What has happened is that my real interest rate, the real cost of borrowing money, has increased.

Now imagine that the economy is in a recession, which is usually the case when deflation occurs.  The central bank wants to increase the money supply by lowering interest rates.  The problem is that there is deflation, which adds to the real interest rate.  Because of the deflation, the central bank cannot lower the real interest rate enough to get businesses to borrow money again.  The deflation has increased the real interest rate and prevented the central bank from using one of its main levers of monetary policy.

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kmuhovic | Student

Before diving into the effects of deflation on the real interest rate, it is important to understand what deflation and real interest rate actually mean.

1.) Deflation: As opposed to inflation, deflation occurs when there is a decrease in the average price level in an economy. This usually occurs when there is a decrease in the overall demand, i.e. aggregate demand, of the economy. 

2.) Real interest rate: Often times, we are given an interest rate quote at our local bank (e.g. 3%). While this usually suffices for basic calculations, this interest rate fails to take into account the effects of inflation. Therefore, this is referred to as the nominal interest rate.

In contrast, the real interest rate takes into consideration the effects of inflation.

The best way to illustrate the difference between nominal and real interest rate is with an example:

Assume that your local bank offers you a 3% interest rate on your savings. At the same time, assume that inflation stands at 2%.

1.) The nominal interest rate for your savings is 3%.

2.) The real interest rate is actually 1% (3%-2%). If you are given a 3% return on your savings, but the overall price level increases by 2%, your real increase in your savings is only 1%.

Therefore, real interest rate = nominal rate - inflation rate.

With that in mind, it is important to understand that the Central Bank uses the nominal interest rate to manage inflation/deflation. Imagine the image of the Central Bank pulling on a lever:

1.) When the average price level begins to increase rapidly (inflation), the Central Bank will pull the lever up to increase the nominal interest rate. By increasing the nominal interest rate higher than the inflation rate, the real interest rate will increase. 

With a higher real interest rate, consumers will be discouraged from taking out loans and encouraged to save their money in the bank. As a result, the aggregate demand should begin to decrease and so should the average price level.

Inflation --> increase in nominal interest rate --> increase in real interest rate --> decrease demand and average price level

2.) However, if the average price level begins to drop too quickly (deflation), the Central Bank will pull the lever down to decrease the nominal interest rate. By decreasing the nominal rate, the real interest rate will decrease.

As a result, with a lower real interest rate, consumers will be encouraged to take out loans and discouraged to save their money in the bank. Consequently, the aggregate demand should begin to increase and so should the average price level.

Deflation --> decrease in nominal interest rate --> decrease in real interest rate --> increase demand and average price level

 

Nevertheless, if the Central Bank pulls the lever all the way down so that the nominal interest rate is already close to zero but deflation continues to persist, then we face a greater problem. 

For example, imagine the the nominal rate is 0.5% and the inflation rate is -2% (deflation implies a negative inflation rate). 

Then: real interest rate = 0.5% - (-2%) = 2.5%

If the Central Bank realizes that this real rate is still too high for consumers to begin spending, it may need to consider other alternatives to stimulate spending in the economy since it will be difficult to reduce the nominal rate any lower.

Other alternatives may include working with the government to reduce income tax so that households have more disposable income. In addition, the Central Bank may resort to Quantitative Easing i.e. printing massive amounts of money to "pump the economy back to life". 

Interestingly enough, some economies, such as Japan, have resorted to negative nominal rates as a means to battle deflation. If you're interested in reading more about that, you can find several articles online.