If an economy
suffers from deflation, the real interest rate will rise. It will then likely become impossible
for a central bank to lower the real interest rate low enough to prompt more people to borrow
money. This is one reason why deflation is something that economists fear.
Deflation can be defined as a drop in the overall price index. This is the opposite of
inflation. When deflation occurs, goods and services in general become less expensive. This
sounds like a good thing because things get cheaper and consumers are able to buy more things
with their paychecks.
Deflation is really not a good thing, though. One major
reason why deflation is bad is that it increases the real interest rate. Imagine that I borrow
$1000 and have to pay 4% interest on that money. At the end of the year, I must pay back
$1040. If deflation occurs, that $1040 is actually worth more than it was when I borrowed it.
For example, it might be worth as much as $1060 at the point when I borrowed the money. What
has happened is that my real interest rate, the real cost of borrowing money, has
increased.
Now imagine that the economy is in a recession, which is usually
the case when deflation occurs. The central bank wants to increase the money supply by lowering
interest rates. The problem is that there is deflation, which adds to the real interest rate.
Because of the deflation, the central bank cannot lower the real interest rate enough to get
businesses to borrow money again. The deflation has increased the real interest rate and
prevented the central bank from using one of its main levers of monetary
policy.
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