Explain inflation, deflation and stagflation. What is the importance of Phillips Curve in an economy? Discuss the consequences of deflation in an economy
The correct answer and explanation is:
Inflation, Deflation, and Stagflation Explained:
Inflation is the sustained increase in the general price level of goods and services in an economy over a period of time. It reduces the purchasing power of money, meaning each unit of currency buys fewer goods and services. Moderate inflation is a sign of a growing economy.
Deflation is the persistent decrease in the general price level of goods and services. It increases the purchasing power of money but can signal a weakening economy. Consumers may delay purchases in anticipation of lower prices, which can reduce overall demand and slow economic activity.
Stagflation is a situation where an economy experiences stagnant growth, high unemployment, and high inflation simultaneously. It is rare and challenging to manage because traditional monetary and fiscal tools to combat inflation may worsen unemployment and vice versa.
Importance of the Phillips Curve:
The Phillips Curve illustrates the inverse relationship between inflation and unemployment. According to this theory, when unemployment is low, inflation tends to be high due to increased consumer spending and demand for goods. Conversely, high unemployment usually results in lower inflation due to reduced demand. The curve helps policymakers understand the trade-offs between inflation and unemployment and is used to guide monetary policy decisions. Although the relationship has weakened in some periods, the Phillips Curve still provides valuable insights into short-term economic fluctuations.
Consequences of Deflation in an Economy:
Deflation can harm an economy in several ways. It encourages consumers to postpone purchases, anticipating lower future prices. This behavior reduces overall demand, leading businesses to cut production, lower wages, and lay off workers, which increases unemployment. Falling prices also increase the real burden of debt, making it harder for borrowers to repay loans. This can lead to higher default rates and financial instability. Deflation can cause a downward economic spiral, making recovery more difficult and prolonging recessions.