Why Some Inflation is Better Than Deflation

Some Benefits of Low Inflation: Inflation causes real interest rates to be lower than nominal interest rates. When businesses make decisions about borrowing, they consider real interest rates. When an economy is facing slow growth, zero nominal interest rates are the limit on how low the Federal Reserve can set interest rates. But with inflation, real interest rates can even be negative and may stimulate borrowing and spending.

Inflation lowers the burden of debt that an individual, business or country may have. Debt is being paid back with dollars that have less purchasing power (adjusted for inflation, the real or effective interest rate is lowered by the rate of inflation).

What’s Harmful about Deflation?

Deflation results in real interest rates being higher than nominal interest rates. This occurs because loans are being repaid with dollars that have more purchasing power. Nominal Interest Rates + Deflation = Real Interest Rates Deflation increases the debt burden of an individual, business or country.

Deflation makes Monetary Policy Ineffective Deflation creeps into an economy that is experiencing very slow growth over a long period of time. Interest rates in such and economy will therefore already be zero bound, much as they currently are in the Euro Area. But deflation causes real interest rates to be higher; this works against the desired expansionary policy of the country’s Central Bank and makes their policy virtually ineffective.

Deflationary Cycle Deflation can also cause a deflationary cycle. It starts when businesses lower prices because demand is low and they haven’t been able to sell their goods. But as prices are lowered, instead of buying, consumers put off their purchases because they expect prices to go even lower. When this happens, businesses lower their prices again and a deflationary cycle (which is very difficult to come out of) has begun.