Question

Most developing countries such as South Africa, Zambia, Tanzania, Mozambique, Nigeria etc, are battling to contain inflation at a desirable levels. on the other hand, some developed economies are battling with deflation. using relevant macroeconomic theories to support your arguments:

a) write a detailed review of the challenges posed by deflation within an economy. your answer should cover all sectors including the business, government and the society as well as other macroeconomic indicators ( GDP,unemployment, interest rate etc). ( 25 marks)

b) As an economist, write a policy to the parliament of a country that is attempting to find the correct policy mix to take the country out of a deflationary period. your policy brief demonstrate a clear understanding of relevant macroeconomic models/theories and must cover both fiscal and monetary policies focusing on all actors of the economy ( business, public sector, government, society etc). ( 25 marks)

Answer 1

a. Deflation is an economic situation in which the general level of prices tends to degrade relative to the general level of inflation. That happens typically when an economy is in a recession where the economy's aggregate demand is weak, because the aggregate demand contributes to a drop in asset prices when their demand falls, which raises the borrowers 'actual indebtedness because the value of their assets declines because of declining prices.

This is taken into account by manufacturers and their output rates are reduced, which further reduces investment demand and rising unemployment. This contributes further to the reduced overall demand. Since people lower price, and they know that rates will drop more in the future so they don't waste their money now.

The financial sector is debt-trapped because its assets are the value of collateral guarantees against the credit because of such low asset prices. This leads to an growing default rate and a liquidity crisis, which decreases banks 'lending ability substantially. This also leads to the decrease in aggregate demand in the economy, resulting in declines in GDP and increasing unemployment.

As GDP decreases and unemployment rises, the policy's revenue also declines, leading to a recession and deflation that contribute to lower overall demand. Government spending also declines. As prices decline, demand declines as customers are not willing to spend today, realizing they will be more likely to purchase tomorrow as prices fall. As the value of the assets in the economy declines, the default rate for loans rises as the financial system collapses.

b. In the event of a deflation that is normally related to recession, expansionary monetary and fiscal policies are the best policy combination to use. The expansionary fiscal policy may be a direct tax reduction or subsidy, or simply an increase in government spending in order to boost aggregate economic demand and help produce in the economy. The unemployment rate will decrease at the beginning of development and the need for investment will also increase.

If this strategy of fiscal expansion is to take place, an increase in demand for money will be made in the economy and the central bank will perform expansionary acts, such as purchasing treasury bonds to allocate fresh liquidity to the economy.

Monetary expansion is also going to lead to rising economic demand that will improve production and jobs and raise prices as supply rises too. Deflation will begin to emerge from the economy.

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