If the economy suffers deflation, what will happen to the real interest rate?
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.
check Approved by eNotes Editorial