Inflation and Deflation

Paper Summary:

This paper discusses the concepts of inflation and deflation and the underlying causes of changes to aggregate supply and demand that may lead to either inflation or deflation. It describes the results of inflation and deflation on an economy and the ways that governments use monetary and fiscal policies to combat inflation and deflation in order to maintain economic stability.

From the Paper:

"During periods of deflation, if the nominal interest rate is already initially low, the Federal Reserve doesn't have much room to continue to lower interest rates. Nominal interest rates cannot fall below zero, since potential lenders would then hold cash rather than lend at negative interest rates. This is called the zero lower bound for interest rates. Once the zero lower bound for interest rates has been reached, monetary policy has difficult addressing deflation because the economy is satiated with liquidity and the private sector is indifferent between holding zero-interest-rate Treasury bills and money. Although open-market operations to expand the money base by buying Treasury bills lead the private sector to hold fewer Treasury bills and more money, this does not have an impact on prices and quantities. This is known as a liquidity trap where expanding liquidity beyond the satiation point has no effect. Once in a liquidity trap, a country can be stuck in it for a very long time."

Sample of Sources Used:

• "Deflation." Investopedia. Retrieved November 21, 2006 from Web site: http://www.investopedia.com/terms/d/deflation.asp
• Hormats, Robert D. "Overshoot? Behind the Curve? Or Just Right?" The International Economy Fall 2005. Retrieved November 21, 2006 from Web site: http://www.findarticles.com/p/articles/mi_m2633/is_4_19/ai_n16057673
• "Inflation." Encyclopedia of American History. Retrieved November 21, 2006 from Web site: http://www.answers.com/topic/inflation
• "Inflation." Wikipedia. Retrieved November 21, 2006 from Web site: http://en.wikipedia.org/wiki/Inflation#The_role_of_inflation_in_the_economy
• "Inflation: What is Inflation?" Investopedia. Retrieved November 21, 2006 from Web site: http://www.investopedia.com/university/inflation/inflation1.asp

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