Question

Who would gain and lose if deflation occurs? Why? What will happen to interest rates and investment according to Keynesian and Classical/ Monetarist theories?

Answer 1

In the time of deflation, the creditors gains and debtors face loss as, the purchasing power of money increases. According to keynesian theory, the rate of interest determines the supply rate of money and hence the investment. At the time of deflation the interest rates goes down, hence money supply increases and investment decreases.

In the classical model, demand and supply are co suffered to be the driving force to decide the money supply, hence during deflation, the supply of money increase and demand reduces hence the equilibrium interest rates goes down and investment reduces.