Your senators claim that lowering prices would be good for everyone-"Who doesn't like lower prices, after all?" They tell you they plan to lobby for deflation. Falling prices could lead to a bad situation because:

a. people will expect prices to start rising and will want to spend more before they do.

b. deflation decreases the value of savings in real terms.

c. they make debt harder to pay back because the real interest rate will be rising, leading to less borrowing and less spending.

d. deflation increases consumption because people like falling prices.

Question

Business

Karson Cabrera

25 August, 13:21

Your senators claim that lowering prices would be good for everyone-"Who doesn't like lower prices, after all?" They tell you they plan to lobby for deflation. Falling prices could lead to a bad situation because:

a. people will expect prices to start rising and will want to spend more before they do.

b. deflation decreases the value of savings in real terms.

c. they make debt harder to pay back because the real interest rate will be rising, leading to less borrowing and less spending.

d. deflation increases consumption because people like falling prices.

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Answers (1)

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Ricardo Robles · Answer 1

c. they make debt harder to pay back because the real interest rate will be rising, leading to less borrowing and less spending.

Explanation:

Interest rate formula can be approximated by:

r=i-π

r: real interest rate

i: nominal interest rate

π: Expected inflation

If the expected inflation is negative (deflation), then the fomrula will be:

r=i - (-π)

r=i+π

If real interest rate increase, it is harder to pay back debts and borrow money will turn more expensive. People will prefer to save rather to spend because they think prices will be lower in the future. This will traduce in lower consumption and then into a recession.