What's wrong with a deflationary economy?

Question

It is my understanding that central banks around the world strive to achieve a stable inflation rate of around 2%. It is claimed that this is because steady low inflation helps contribute to the economy's prosperity. My question is regarding this claim, that steady low inflation is better than a deflationary economy (one with high consumer purchasing power and negative interest rates).

In a deflationary economy with negative interest rates, savings would be discouraged while spending and investments would be encouraged (since you would lose money by keeping it in a bank), thus stimulating the economy. I am not really convinced by the argument that consumers/businesses would decrease spending in anticipation of lower prices since they would still need to purchase essential goods and services. Instead, it might reduce impulsive spending common in inflationary economies. I do realize that debt will indeed become more expensive, as its real value would increase, however, decreased interest rates and the reduced need to borrow (due to increased purchasing power) might balance this out. Even if it does not entirely offset the increase in debt value, this seems like it may be a transitional problem that would only exist when transitioning from an inflationary economy to a deflationary one.

The inquiry stems from the observation that inflation tends to decrease as globalization and technological advancements increase, both of which are associated with economic prosperity. Yet, the central banks around the world keep trying to reverse those effects by artificially increasing the rate of inflation claiming that it is better for the economy. The only negative I can see from a deflationary economy is that banks and financial institutions would make a lot less money. However, as far as I can tell, the consumer and the economy as a whole would benefit from such a model. The only times we have experienced deflationary economies was in times of financial crisis, which may be why we have the current conception of deflation being something to avoid at all costs. I am wondering if the model described above is practically possible and if it would work as I laid out if achieved.

(I have a very basic economic background and have been trying to better understand how things work on a macro level very recently so excuse any oversights)

Answer 1

This is not a matter that can be answered just by intellectual arguments around what behavioral motives and tendencies does inflation and deflation create in an economic agent and by extension at the macro-level. Most are plausible, so the question becomes "which dominates quantitatively"?

But in any case, even these qualitative arguments must be comprehensive enough. When the OP writes

In a deflationary economy with negative interest rates, savings would be discouraged while spending and investments would be encouraged,

it begs the intertemporal question "with discouraged savings, the funds available for investment will tend to be less and less as time passes, so what will happen over the medium/long term?"

This is a real question, not a rhetorical one.

I would suggest to contemplate "why inflation/deflation and not constant prices" which will give an insight as to the possible reasons why prices tend to change regardless of "monetary policy/quantity of money" and the like.

Answer 2

3 problems with deflation, other than what you already pointed out which is that "consumers/businesses would decrease spending in anticipation of lower prices".

• Decreased spending in anticipation of lower prices causes more deflation, in other words, a feedback loop. A feedback loop can be painful.
• It's hard to impose significantly negative interest rates since people can avoid using accounts that have a rate that is much more negative than say negative 1% per year. At negative 2% people might hold more cash. If there is a feedback loop, you might need a significantly negative interest rate.
• In general under-pricing and overpricing are not good. At all times there is something in the economy that is overpriced. If it is goods or commodities bought on long term contracts, we have to wait for the term of the contract to be over before there is a repricing. If it's labour that is overpriced, it's hard to decrease the price of labour because it might affect worker productivity in a way that makes it not worthwhile to decrease the price of labour. Instead of reducing the contractual prices, we can just have 2% inflation which means overpriced goods, commodities, and labour become cheaper without waiting for the end of contracts and making workers annoyed or furious or inducing shirking, or causing workers to "go postal", etcetera.