Question

Why did Keynes believe that downward price flexibility (deflation) could be destabilizing and not stabilizing as the classical model assumed.

Answer 1

Keynes believed deflation to the destabilizing because deflation will increase the tendency to save (MPS) as the real value of money will be higher in the coming future time than the present time. Due to this reason, households will spend less and less demand will be created. With lower demand, new capital investment by the firms will not take place. As a result, new employment opportunity will not be created. It will further lower the demand and more deflationary effects will be seen in the economy. It is destabilizing as it will never help the economy to recover from the recession. So, Keynes believed deflation to be destabilizing for the economy.

Though, the classical model thought differently and believed that lowering prices will encourage the demand and economy will recover without increase in saving tendencies. But, it does not happen as per the Keynesian views.