Readers Question: From the current economic crises government has been slashing its base interest rates to now 2%. However, how would deflation which is currently being experienced in several countries mainly due to decreasing fuel prices affect the attempted recovery from this crisis?
Deflation makes monetary policy much less effective. In fact deflation can cause a liquidity trap which implies a cut in rates will have no effect on boosting demand.
- Firstly, deflation can increase the real interest rate. Suppose we have deflation of -2%. Interest rates cannot fall below 0%. Therefore, the real interest rate is effectively 2%. This will discourage borrowing and investment. (At the moment, we have negative real interest rates because inflation is higher than base rates; in theory this should encourage people to spend and invest. A fall in prices has the effect of making monetary policy tighter.)
- Deflation discourages consumer spending because consumers expect prices to be cheaper in the future, therefore, they delay purchasing leading to lower aggregate demand. The evidence of Japan suggests this is a real problem.
- Deflation also increases the real value of debt. Firms and consumers spend a higher % of their income on paying off debts leading to lower growth.
See also Problems of deflation.
Solutions to Deflation
Deflation can be very damaging for attempts to avoid a recession. Monetary policy can play a role in avoiding deflation and recession.
Zero interest rates. Firstly Central Banks can reduce base interest rates to zero. Lower interest rates reduce cost of borrowing. However, with deflation, zero interest rates will not be enough to avoid a fall in economic growth
Quantitative Easing. The Central Bank can electronically create money and use this to buy bonds (both government and other financial bonds). This helps to
- Increase the money supply. Bank reserves should rise; in theory this should encourage them to lend more
- Lower interest rates on long term bonds. By purchasing bonds, the Central Bank will reduce interest rates on bonds. These lower interest rates can help to encourage lending and spending. E.g. in 2011, the US Fed unveiled ‘operation twist’ this involved buying mortgage securities to reduce interest rates on mortgage bonds. The hope was this would encourage mortgage lending
- More on quantitative easing
Inflation Target. The Central Banks can make it very clear they are targetting positive inflation. They could even increase the inflation target from 2% to 3%. Increasing inflation expectations help to avoid the pressure of deflation