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Economists say that deflation leads people to postpone their consumption because it increases the value of their money and gives them the ability to consume more in the future. But if a consumer saves his money in a bank with a positive interest rate, the value of the money also increases. Let's assume we have two situations:

  • We have 5 % deflation. The consumer has 1000 dollars. If he postpones his consumption for a year, the real value of 1000 dollars will be $\frac{1000}{0,99}\doteq1010$.
  • Now we have a 5 % nominal interest rate. If I put 1000 dollars into a bank, I will have 1050 after one year. Let's assume that we have 3,9 % inflation. Then the future value of my money in today prices is again $\frac{1050}{1,039}\doteq1010$

So why is the deflation considered to be such a big danger for an economy?

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  • $\begingroup$ @denesp I don't believe so. $\endgroup$ – Jiří Pešík Feb 17 '17 at 8:27
  • $\begingroup$ Perhaps you could give the first answer a closer look. $\endgroup$ – Giskard Feb 17 '17 at 8:29
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Deflation means decreasing prices, but with the rigidity of wages (although this depends on the country in which you are), it means (i) higher unemployment rates or/and (ii) lower profits.

(i) higher unemployment means less consumption and thus more deflation which drives the economy into a vicious circle.

(ii) lower profits means lower investment in production capacity or R&D, etc... and also lower dividends, which to me is more desirable than (i). Since the majority of people are less exposed to variation in capital income than in wages, but this is political.

In this framework, if the central bank plays its counter-cyclical role, key rates should decrease to discourage savings, conditionally to the fact that those are not already too close from 0.

But I would say that in reality, many other determinants must be taken into account. Actually the trajectory of your economic system with its inertia, etc... e.g.: the fact that this deflation is imported or not; the fact that the forecasted rentability of investments in alternative production capacities are conditional to high (or at least stable) prices so as to be competitive (example of renewable energies VS a decreasing fuel price); the shareholding structure of the economy under question, etc... Thus it may not be dangerous.

You cannot figure out why the deflation is considered to be such a big dangerous for the economy with the (partial equilibrium) numerical example you give.

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