Why is deflation costly?
Deflation is essentially just the opposite of inflation. Therefore, the reasons that inflation is costly will tend to apply also to deflation. For instance, like an unexpected inflation, an unexpected deflation will tend to redistribute wealth between borrowers and lenders when debt contracts are not indexed. Deflation also degrades the efficiency of the price system as resource allocator and adds complexity to people’s and firms’ decisionmaking. It also distorts the tax treatment of capital because taxation generally uses nominal income rather than real income as the tax base. When the economy is in a prolonged recession, a deflation can be even more costly than an inflation, as couple of factors may come into play and worsen the situation. First, if the short-term nominal interest rate is already low, declining inflation and the Federal Reserve policy actions to stimulate the economy may eventually push it toward zero. Because the nominal interest rate cannot be reduced further, wors
