Deflation is a scenario where there are falling prices of goods and services across the economy. Although the ability to purchase goods and services at a discount may sound like an ideal situation, it has the potential to cause a lot of problems throughout the economy. Some common problems of deflation are a decrease in consumer spending, increased interest rates and an increase in the real value of debt.
When deflation is occurring, consumers often slow their spending, thinking prices will fall further. This leads to a lag in economic growth and pressures the economy as a whole. Deflation tightens the money supply because there are increased real interest rates, causing consumers to save money. It hinders the revenue growth of firms, causing workers to get paid lower wages or potentially laid off. This leads to higher unemployment rates and lower growth rates.
Real Value of Debt
All of these problems can increase the real value of debt. During times of deflation, since money supply is tightened, there is an increase in the value of money, which increases the real value of debt. This makes it harder for borrowers to pay their debts. Since money is valued more highly during deflationary periods, borrowers are actually paying more because the debt payments remain unchanged.
For example, suppose the government of Greece owed $100 billion to the United States in the previous year. Thinking in terms of oil, the government could have bought 100 million barrels of oil. However, this year, Greece is experiencing a deflationary period and could buy 200 million barrels of oil with the same amount, since the prices of goods and services decrease. Its debt stayed the same, but now it is actually paying more – 200 million barrels of oil as opposed to 100 million. Deflation can cause the real value of national debt to rise.