Deflation and Interest Rates

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Student1410
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#1
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#1
How does deflation increase interest rates?
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PaulKrugman
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#2
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Depends on which interest rate you're referencing. BoE's? Interest rates between banks and businesses?
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MR95
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inflation is the general rise in price level , so deflation means a general decrease in price level , but i think the interest rates will rise because the government need some money back from what they've lent out so that higher interest rates mean if people borrow they pay back more and that would stabilise the economy due to the fact that inflation is decreasing. if that helps ?
if not deflation causes prices to decreases so commodities and house prices would decrease this would mean people would want to spend more , however if intrest rates are high they will borrow but however would have to pay back more in return.
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NikolaT
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(Original post by MR95)
inflation is the general rise in price level , so deflation means a general decrease in price level , but i think the interest rates will rise because the government need some money back from what they've lent out so that higher interest rates mean if people borrow they pay back more and that would stabilise the economy due to the fact that inflation is decreasing. if that helps ?
if not deflation causes prices to decreases so commodities and house prices would decrease this would mean people would want to spend more , however if intrest rates are high they will borrow but however would have to pay back more in return.
Surely a simpler answer at A-level would just be:

Central bank policy is a 2.0 target for inflation
Deflation is way, way below 2%
To bring it back up, demand-pull inflation
They would lower interest rates to stimulate borrowing and consumption
Aggregate Demand would rise
<insert graph here>
Inflation starts rising again

Or am I missing something?
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MR95
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(Original post by NikolaT)
Surely a simpler answer at A-level would just be:

Central bank policy is a 2.0 target for inflation
Deflation is way, way below 2%
To bring it back up, demand-pull inflation
They would lower interest rates to stimulate borrowing and consumption
Aggregate Demand would rise
<insert graph here>
Inflation starts rising again

Or am I missing something?
so how would deflation increase interest rates ? delfation increase intrest rates wouldnt it ?
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Guru Jason
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#6
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#6
(Original post by MR95)
so how would deflation increase interest rates ? delfation increase intrest rates wouldnt it ?
Personally i would say it wouldn't. Increased interest rates means people save more and thus less spending. I would argue that lowering the interest rates to force spending increases and in turn stop deflation and create inflation again.
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MR95
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#7
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(Original post by Guru Jason)
Personally i would say it wouldn't. Increased interest rates means people save more and thus less spending. I would argue that lowering the interest rates to force spending increases and in turn stop deflation and create inflation again.
too much inflation is bad right ? for the long term effect and how all the prices would rise therefore it could stop and cut down consumer spending and consumer confidence , therefore the interest rates could be lowered !
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Guru Jason
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#8
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#8
(Original post by MR95)
too much inflation is bad right ? for the long term effect and how all the prices would rise therefore it could stop and cut down consumer spending and consumer confidence , therefore the interest rates could be lowered !
Hyperinflation is bad. Inflation is good and is needed for the economy to grow. Deflation is very bad as this means the economy is shrinking. Inflation of around 3-5% I would say is needed for a steady stable growing economy in the UK.
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leinad2012
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#9
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#9
(Original post by MR95)
so how would deflation increase interest rates ? delfation increase intrest rates wouldnt it ?
No, in almost all cases it wouldn't unless most of the AD of that country in question was composed of investment, in which case an increase in interest rates would cause an influx in investment.

But I don't think a central bank would ever increase interest rates to deal with inflation, only decrease to increase demand pull inflation
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leinad2012
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#10
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(Original post by Guru Jason)
Hyperinflation is bad. Inflation is good and is needed for the economy to grow. Deflation is very bad as this means the economy is shrinking. Inflation of around 3-5% I would say is needed for a steady stable growing economy in the UK.
I don't want to be mean but pretty much all of what you've said is bs there.

Deflation doesn't necessarily mean an economy is shrinking, but suggests it may do so in the near future, as deflation is an indicator that consumers are putting off purchases or purchasing from abroad, which could as you said cause GDP to decrease and make the economy shrink.

As for inflation rates the target set by the government to the MPC and BofE is 2%, which is probably a better figure, but the main concern is that the inflation is steady to cause steady growth, in the UK that may be 2% in India it may be 8-10%.
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Guru Jason
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#11
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#11
(Original post by leinad2012)
don't want to be mean but pretty much all of what you've said is bs there.

Deflation doesn't necessarily mean an economy is shrinking, but suggests it may do so in the near future, as deflation is an indicator that consumers are putting off purchases or purchasing from abroad, which could as you said cause GDP to decrease and make the economy shrink.

As for inflation rates the target set by the government to the MPC and BofE is 2%, which is probably a better figure, but the main concern is that the inflation is steady to cause steady growth, in the UK that may be 2% in India it may be 8-10%.
I respectfully disagree. I may have simplified it a lot but I still think its still right.
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leinad2012
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#12
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(Original post by Guru Jason)
I respectfully disagree. I may have simplified it a lot but I still think its still right.
You're correct that hyperinflation and deflation are bad, I agree with that but deflation is merely an indicator that GDP and economic growth will be negative, it does not necessarily mean that it is. And no offence but 3-5% is far too high, on par with pre crash levels. You would want between 1.5-2.5% really hence why there is a 2.0% target which pretty much all economists agree is a sustainable target.

That was my only major disagreement with your statement
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Guru Jason
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(Original post by leinad2012)
You're correct that hyperinflation and deflation are bad, I agree with that but deflation is merely an indicator that GDP and economic growth will be negative, it does not necessarily mean that it is. And no offence but 3-5% is far too high, on par with pre crash levels. You would want between 1.5-2.5% really hence why there is a 2.0% target which pretty much all economists agree is a sustainable target.

That was my only major disagreement with your statement
If economic growth is negative then the economy is shrinking or am I missing something? If prices are falling (deflation) then surely is one cause of it.

Post crash, a target of 2% ish like you said is good. The economy had it's most successful growth pre crash with it's inflation at around 3-5% IIRC

Edit: All said, I suppose, so long as wage increase stays just below the inflation rate, in theory, it shouldn't matter.
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leinad2012
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#14
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#14
(Original post by Guru Jason)
If economic growth is negative then the economy is shrinking or am I missing something? If prices are falling (deflation) then surely is one cause of it.

Post crash, a target of 2% ish like you said is good. The economy had it's most successful growth pre crash with it's inflation at around 3-5% IIRC
yes econ growth being -ive means the economy is shrinking, but deflation is separate from GDP, the measure of how fast and economy is growing/shrinking. You are correct that deflation can be a cause, but there are many other factors, hence why deflation can merely just be an indicator.

Yes atm 2% is a sensible aim atm, but the HUGE flaw in saying that the target should be 3-5% because economic growth was highest pre crash is that it pretty much CAUSED the crash, the growth was not sustainable and created a bubble which led to recession.

Economic Growth that is very high is not always good, especially when it cannot be maintained, which seems to be something which people forget quite quickly... *sigh*
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NikolaT
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#15
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#15
(Original post by Guru Jason)
If economic growth is negative then the economy is shrinking or am I missing something? If prices are falling (deflation) then surely is one cause of it.

Post crash, a target of 2% ish like you said is good. The economy had it's most successful growth pre crash with it's inflation at around 3-5% IIRC

Edit: All said, I suppose, so long as wage increase stays just below the inflation rate, in theory, it shouldn't matter.
I think you're confusing deflation numbers with growth figures. Deflation is a sign of growth and its projection - however, deflation in itself is not a core aspect of it.

For inflation, 2% is the target. For GDP (for all intents and purposes, economic growth) a little bit higher would be sufficient for sustainable growth.

You said the most successful growth before the crash was with inflation between 3-5%. It only climbed upwards of 3% towards 5% in '08. As it happens, the economy was in a pretty bad recession in '08, and some of '09.

Getting too high above 2% is simply not good for stable, sustainable growth.
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leinad2012
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#16
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#16
(Original post by NikolaT)
I think you're confusing deflation numbers with growth figures. Deflation is a sign of growth and its projection - however, deflation in itself is not a core aspect of it.

For inflation, 2% is the target. For GDP (for all intents and purposes, economic growth) a little bit higher would be sufficient for sustainable growth.

You said the most successful growth before the crash was with inflation between 3-5%. It only climbed upwards of 3% towards 5% in '08. As it happens, the economy was in a pretty bad recession in '08, and some of '09.

Getting too high above 2% is simply not good for stable, sustainable growth.
This was what I was trying to explain (probably quite badly!). Deflations just an indicator, but all of the figures and measures can be confusing when you're starting off!
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MagicNMedicine
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#17
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#17
I wonder if the OP is getting confused between nominal and real interest rates.

Deflation isn't going to directly drive up nominal interest rates: in a country whose monetary policy is targeted on an inflation target, deflation is more likely to make the central bank cut nominal interest rates in response.

However real interest rates (the real value of what you have to repay in terms of what it would buy in goods and services) will depend on nominal interest rates and the rate of inflation.

The formula is (1+real interest rate) = (1+nominal interest rate)/(1+inflation rate)

If the nominal interest rate on a loan is 5% and the current rate of inflation is 2% so

(1+real interest rate)=1.05/1.03
1.0194 = 1.05/1.03

The real interest rate is 1.94%

Now if the rate of inflation falls to say -1% (deflation of 1%) while the nominal rate is unchanged then that becomes

(1+real interest rate)=1.05/0.99
1.0606 = 1.05/1.03

The real interest rate is 6.06%
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