Home > Deflation, Fiscal Policy > The Perils of Deflation

The Perils of Deflation

December 18, 2014 Leave a comment Go to comments

DeflationFor so long central banks and policy makers have been obsessed with inflation but with inflation falling the dangers of deflation are now on the horizon. In the USA, Britain and the euro zone inflation is dropping below the 2% target and Japan is struggling to maintain higher prices. Why is deflation bad:

1. Money made today will be worth less tomorrow so investment is discouraged
2. Goods cheaper tomorrow reduces consumption and therefore aggregate demand
3. Central banks struggle to set real interest rates which are stimulatory
4. People who borrow money find that what they owe is worth more in real terms
5. Demand runs below the economy’s capacity to supply goods and services leaving an output gap. This can lead to unemployment and wage cuts which worsens the situation

One of the main problems at present is the fact that Central Banks are running out of ammunition – interest rate cuts – as rates are close to 0%. Therefore in order to stimulate demand they now have to use fiscal policy and more government spending would assist especially in areas that are in need – e.g. roads, bridges etc.

Would US public infrastructure spending drive up prices?

Some alarming figures have been banded about with regard to America’s infrastructure. It is estimated that over 700,000 bridges are rated as structurally deficient. In 2009 Americans lost approximately $78 billion to traffic delays – inefficient use of time and petrol costs. Also crashes which to a large extent have been caused by road conditions, cost a further $230 billion.

According to the American Society of Civil Engineers the US needs to spend $2.2 trillion bring their infrastructure up to standard. The Congressional Budget Office estimated in 2011 that for every dollar the federal government spent on infrastructure the multiplier effect was up to 2.5. Other indicators state that every $1 billion spent on infrastructure creates 18,000 jobs, almost 30% more than if the same amount were used to cut personal income taxes. – The Economist

Positive Externalities from infrastructure.

Investment in infrastructure has a lot of positive externalities – faster traveling time for consumers and companies, spending less time on maintenance. Research has shown that the completion of a road led to an increase in economic activity between 3 and 8 times bigger than it initial outlay with eight years after its completion. But what must be considered is that now is the best time to invest in infrastructure as it is very cheap – much cheaper than it will be when the economy is going through a boom period.

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