Deflation is when prices of goods and services fall across the economy.
But why is this a bad news for the economy? If we experience deflation, we would be able to buy more goods as the year before. Why are central banks and governments worried about the prospect of deflation? I will point out three reasons why deflation is a more serious problem than inflation.
Why is that a problem? If you are looking to buy a car as a customer, you will wait until the last possible moment to spend your money because you know that if you wait long enough, you will get a better deal. This consumer behavior is worsening the total demand for new cars. In a consumer-oriented economic system, this is a devastating scenario. Basically, anyone looking to spend a large sum of money is going to wait as long as possible, delaying their purchase, therefore reducing the demand for goods and services.
Deflation discourages borrowing of money. Additionally, to printing money, central banks around the world also set interest rates. These interest rates should regulate the rate of money borrowing. The lower the interest rate, the more money should be borrowed. When you combine low-interest rates with positive inflation, you encourage people to borrow money. At the moment the interest rates in the EU are around 0%. Even though the rates are at historic lows, people are still conservative. Even with such aggressive policies, the European Central Bank cannot get people to borrow money. Deflation causes another problem for central banks. If the interest rates are set to 0%, and we experience deflation, the real interest rate would be still positive, worsening the central bank's power. This means your money would grow as savings.
Let’s take for example a house mortgage. A 30-year mortgage on a house has evenly distributed monthly payments. If you experience inflation in the economy, your monthly repayment should feel less and less as the time passes, because the inflation would devalue your debt and rising wages should also lead to a more manageable repayment. In a deflationary scenario, you should experience the opposite. With a deflation, a mortgage would put a higher burden on you with every year since prices will be falling. You will end up with a very expensive repayment especially in the last years of the mortgage. On top of that deflation would lead to lower wages, so you end up earning less money in nominal terms. Ask yourself the following question: Why should I buy a house if the value of the home is falling?
But wait a minute! Why is deflation terrible when my money savings rise in value with the time? Well, deflation is good for consumers but devastating for companies and businesses because these are looking to invest in for example real estate projects. That's why the big guys are scared of deflation.
