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Peace asked in Social ScienceEconomics · 7 years ago

costs of low inflation?

I only know the costs of INFLATION but i cant find the costs of LOW INFLATION

there must be some...


3 Answers

  • 7 years ago
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    One disadvantage of low inflation is that it hinders the ability of the central bank to fight severe recessions. To explain this, you should consider the following general points first:

    a) the central bank fights recessions by lowering real interest rates.

    b) the real interest is equal to the nominal interest rate - inflation. (r = i - π)

    c) the real interest rate is what firms and households normally consider for investment and consumption decisions; a lower real interest rate will induce firms and households to borrow and spend more, thus increasing the number of people who are hired to produce those things (say a company borrowing money to purchase machinery, which will have to be replaced or made by the providers of that machine; this will require labor, which will be hired. The laborers will get paid, and will spend on other products; there will in turn be additional people hired to meet the demand the laborers have generated for those products.)

    d) The central bank can control real interest rates because prices are slow to adjust for various reasons. So remember this equation again: r = i - π. If the central bank reduces i (the nominal interest rate), and prices are very sticky (that is, π is very slow to adjust relative to the increase in the money supply that reduces i), then the reduction in i will translate to a reduction in r (the real interest rate) which will increase employment and output.

    Ok, so those are the points.

    Now, say inflation is 2% coming into a severe and nasty recession; let's call it the Lesser Depression (comparing it to the Great Depression of the 30's). And let's say the nominal interest rate is 5%. The severe recession will make the central bank reduce the nominal interest rate all the way to zero, and given that inflation is 2%, the real interest rate is negative 2%. And given that inflation will come down more due to so many workers being out of work and not spending as much as they could to make the economy produce what it could potentially, inflation will probably slowly go down to 1%, making the real interest rate negative 1%.

    The recession the US experienced in the late 2000's required a much lower real interest rate (yes, I know, that's pretty surprising) than that to get the economy speedily back to where it normally should be.

    So what would have happened if inflation was say, 4%, coming into the recession? Well, the nominal interest rate would have probably been 7%. The central bank would have reduced it to 0 to fight the recession. The real interest rate would then be negative 4%, and given that inflation would probably decline a bit, it would still be around negative 2% to negative 3%. This would have had a much more positively stronger impact on the economy and helped the recession to be more mild and of less lengthiness.

    Another disadvantage could be that lower inflation will have perverse consequences for an economy in which a giant and important section of that economy (say, many many households that had borrowed a lot of money) has a lot of debt on their hands.

    Low inflation will hinder their ability to pay down that debt effectively and in a timely manner. The reason is that the value of debt households have (say, a $500,000 dollar loan held by a household that used it to buy their house) does not change with inflation. So if prices, and hence wages and the income people receive, rose 10 percent in a year, the value of that debt ($500,000) would not change with it. This would leave the household with a higher income relative to that debt, and make it easier to service it. In effect, the value of the debt the household holds has eroded due to higher prices in the economy. This leaves the household less constrained by their debt, and enables them to spend more, thus buoying the economy. If inflation is persistently low and their debts sufficiently large, the reverse process occurs and the economy will remain depressed for a long period of time.

    Another disadvantage is that low inflation is really close to outright deflation; that is, a decrease in the price level. Deflation is generally bad for an economy, because it increases the burden of outstanding debt, which can have bad consequences for financial institutions like banks. (<---this is what happened in the Great Depression. A precipitous fall in the price of many agricultural products meant that farmers could not earn enough money to pay back their loans to agricultural banks, which left those banks in big trouble.)

    Deflation also increases real interest rates, which serves to worsen a recession and thus reinforce the deflation that is occurring. Deflation also makes people tend to put off purchases of stuff, since they continuously expect the prices of those products to decrease further in the future. It therefore makes people want to sit on cash, which in modern economies is really really bad.

    Hope this helped

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  • Anonymous
    7 years ago

    The most proved cost of low inflation is unemployment. It is demonstrated by the Phillipp's curve which is negative sloping between inflation and unemployment.To prevent it, the FED has turned to inflation targeting of 2-3%. If it is lower,there is possible to increase QE and lower interest rate.

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  • 7 years ago

    Decreased demand

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