Unit 4 June 2011: Essay 2 Question 10 PLAN (INFLATION)

10) To What extent might it be argued that inflation is preferable to deflation?

Introduction and Development:

  • Inflation(DEFINITION)
  • Deflation (DEFINITION)- UK last suffered deflation in the 1930s where it was between 3-5% 

POINT 1 – Economic Costs of Deflation 

  •  Deflation has proved to have several economic costs and one of the main one is discouraging consumer spending
  • This is where due to the price decreasing persistently the consumers not spend as they would to see or expect the price to decrease more. So consumer spending halts leading to a decrease in Aggregate demand. Therefore potentially economic growth.
  • Additionally people in debt the real value of debt would increase leading to household having to spend a bigger proportion of their disposable income paying off the debt.

However:

  • Need to consider what type of deflation it is- there are two types BENIGN AND MALIGN  deflation. It could be BENIGN instead which is just the improvement of the supply side leading to lower prices. This could help to boost economic growth in the long term. 

Point 2: Costs of Inflation

  • Inflation’s economic costs would include damage to competitiveness as domestic goods would be more expensive not attracting any exports—> decrease in AD. 
  • Additionally also poses a uncertainty to people to spend and invest as they don’t know what the future holds. Business will be unsure of future profits therefore won’t tend to invest so decrease in AD. 
  • Due to this may lead to unemployment as more costs to firms aswell( menu costs)

However: 

  • In terms of unemployment deflation tends to be more harmful as in deflation the nominal wages may have to be cut and no one likes this see their actual wages being cut. so in periods of deflation there will be increase in real wages leading to real wage unemployment. 
  • However we do have to consider how big are these drops as if it is only a 1% decrease in prices it would not really affect the consumers. If it is was 5% it would show effect. 
  • Where in the economy are we? Are we in boom period where the economy may be near over capacity. Therefore a decrease in prices is needed. 

Point 3 – Deflation is said also cause a real decrease in interest rates as interest rates cannot decrease below 0%. So if there is deflation of 2% it would cause real interest rates to increase 2%. So it means there is unnecessary tightening of the monetary policy. This would affect Economic growth vastly 

OVERALL- I believe Inflation is preferable than deflation, both are said to be the cause of uncertainty but it seems deflation seems to have a bigger effect. There is a bigger risk of economic contraction than inflation through the lack of consumer spending. It is said that inflation and deflation is not symmetrical as 4% inflation is reasonable but 4% deflation would disastrous. We do have to consider the degree of deflation- how big is it and is it through supply side improvements. It seems Malign deflation is worse than inflation.

 

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