Letters on various blocks that spell Deflation.What is deflation?

Deflation is, in its essence, the exact opposite of inflation. Deflation occurs when less currency is in circulation, and the value of an economy’s currency begins to rise. This causes prices to drop as currency becomes inherently more valuable. While this may sound like a particularly good thing, this isn’t necessarily the case. There are good and bad effects of deflation that can be highly risky to the economy, depending on the situation. Here is a rundown of the dangers of deflation...

Why is deflation bad?

While inflation causes the nominal interest rate to rise, that doesn’t actually mean you are spending more money in interest rates. Nominal interest rates aren’t damaging, because the value of currency that you are paying is dropping to balance out the increase in the nominal interest. Deflation can lower nominal interest rates, but once it hits the zero bound, it causes the real interest rate to rise because the money that you are paying is inherently more valuable. This causes borrowing to drop, which is incredibly damaging to the rate of investments.

Risks of a banking crisis

These effects of deflation raises the risk of default on bank loans, making the act of loaning much more risky. This causes the banks to be less likely to loan, while also making existing loans more volatile. Because most likely less than the balance on the loan, this means that banks will begin losing on each of their existing loans, causing the all lending to cease, creating a banking crisis.

Monetary policy

Typically, monetary policy is controlled by manipulating nominal interest rates. This gives the central bank the ability to make changes in the economy without actually raising the amount that individuals are paying in interest. However, once deflation lowers the nominal interest rates to the zero bound, then there is no way for monetary policy to be made this way, as they cannot cut nominal interest rates any further. At this point, the central bank becomes unable to have any effect on the economy, which will then begin to spiral. This is exactly what happened in 2008 with the Great Recession.

Raises in unemployment

Regardless of the changing fluctuations of the market, workers usually resist drops in wages. Essentially, deflation will cause real incomes to rise, as the currency becomes more valuable, while most employers will find it difficult to cut wages to match the increase in value. These pay cuts, while bad on the surface, are only nominal, and not real ones. Still, workers will naturally resist this, which will result in layoffs occurring and output dropping, lowering GDP.