Why is deflation bad for economy? [duplicate]

Question

As now many people are talking about the inflation of US dollar on the account of the COVID-19 pandemic and the printing of trillions of US dollar bills, the price of decentralized cryptocurrencies like Bitcoin, which are not controlled by any central banks has skyrocketed. Also these cryptocurrencies are deflationary, i.e. they tend to get value increasingly more expensive.

However, many economists state that deflation is worse than inflation. I just can't understand why. Will it not be good for people to have their money valued? Or the prices go down? Why is it bad for economy? Or is it just a story told to make people believe in it?

Answer 1

First of all it is important to make clear what economists are actually saying. Most economists believe that moderate inflation is better than moderate deflation, while high inflation or deflation would be considered undesirable. This is because both inflation and deflation are examples of price instability and in fact if all markets would be perfect, competitive and all prices fully flexible models tend to show that it would be desirable to have neither inflation or deflation over business cycle (you can see some example of such models in Romer Advanced Macroeconomics).

However, unfortunately we do not live in a world where all markets are perfect, competitive and where all prices are flexible. For example, wages might not be flexible because of minimum wage laws or because in many countries contracts are set for long term (for example, in the Netherlands where I live it is very difficult to fire someone with permanent contract or to force them to renegotiate their contract). However, even in countries where labor markets are more flexible it might be difficult to renegotiate wages or contracts quickly.

These rigidities create problem for an economy during recessions where in order for markets to equilibrate you usually need people to accept lower wages. Inflation, solves the issue above because it decreases people's wages in real terms without any need for negotiations. This can help to moderate recession because if real wages are too high during recession it will lead to above equilibrium level unemployment. In turn higher unemployment means people have less income to spend or invest which then just further reinforces the recession.

Also note while I focused mainly on wages the inflation has also other benefits as in the short-run it stimulates the economy (since higher product prices motivate firms to produce more before they realize they are higher due to inflation), it also helps to relax government budget constraint since government as a monopolist producer of money benefits from inflation and has some further benefits (see discussions of this in standard macro textbooks such as Blanchard et al Macroeconomics: A European Perspective or Mankiw Macroeconomics).

Lastly note that economy usually has no problem when it needs to increase aggregate wages during expansion. Wages are much more rigid downwards than upwards and consequently economy usually does not need deflation during expansions when real wages tend to increase.

Hence to sum up, most economists believe that it is better to have moderate inflation (most economists would argue around 2% per year), because it helps to 'grease' the wheels of economy. Inflation helps to moderate business cycle and to the extent that one agrees it is better to have milder recessions it is obvious policy prescription given our current understanding of macroeconomics.

Answer 2

Historically deflation is associated with a large negative output gap during, for example, the Great Depression and the Great Recession:

https://www.economicshelp.org/blog/glossary/output-gap/

An undesired negative output gap with high unemployment and debt default means the economy performs well below its previous capacity (trend line) for long periods of time. This means wealth is not growing as fast as it would in a counter-factual world with mild inflation.

This paper describes models of debt deflation:

https://www.bis.org/publ/work176.pdf

This paper, Minsky Meets Secular Stagnation, describes unsustainable borrowing by working class households as the cause of so-called secular stagnation:

https://cpb-us-w2.wpmucdn.com/sites.wustl.edu/dist/8/2623/files/2020/06/Minsky-SecStag-SF.pdf

In brief summary form, the argument is as follows. A major reason for stagnation is that high-income households recycle a substantially smaller share of their pre-tax income back into spending. Therefore, as inequality rises and most of the growth of income goes to the top slivers of the income distribution demand growth stagnates, other things equal. While this basic story might suggest rising inequality is sufficient on its own to explain stagnation, the distribution channel alone must face what seems on the surface to be a major empirical inconsistency. Income inequality began its persistent march upward sometime between the mid 1970s and early 1980s, decades before secular stagnation was evident. This is where Minsky enters the explanation. A massive boom in household borrowing created a classic expansion phase of a long Minsky cycle from the mid 1980s (at the latest) to the eve of the Great Recession. This dynamic kept household demand growth reasonably strong for more than 20 years, masking any potential demand drag from rising inequality. But the collapse of the recession, a classic Minsky crisis, wiped out unsustainably financed household demand. Household demand has not recovered its pre-crisis trend—the stagnation of higher inequality has come home to roost.

Answer 3

One issue is the possibility of a deflationary spiral. Deflation decreases output, which lowers wages, which lowers demand, which drives more deflation as price drop. This can stretch on for a long time, and some economists think it's one of the mechanisms that made the Great Depression so bad. Low output essentially compounded on itself through deflationary pressure, and it didn't end until governments got off the gold standard and then spent a boatload of money during WWII, driving up demand and increasing inflationary pressure.

There are also limits to traditional monetary policy tools when counteracting deflationary pressure as opposed to inflationary pressure - you can raise interest rates as high as you want to fight inflation, but you can't really go below 0 to fight deflation.

So, we see a $2 \%$ inflation target as coming from the perspective that the slight economic cost of low inflation (to creditors and people who hold cash) is better than the risk of deflation.