What is deflation and why might it be harmful to the macroeconomy in the short run?

• A. A rise in the general price level
• B. A stable price level
• C. A sustained decrease in the general price level; deflation raises real debt burdens and can reduce spending and investment
• D. A temporary stagnation of prices with no effect on debt

Answer: (C)

Deflation is a sustained decrease in the general price level. When prices fall over time, the value of money rises, but debt remains fixed in nominal terms. That makes the real burden of existing debt harder to carry, squeezing households and firms' balance sheets and leading them to cut back on spending and investment. At the same time, deflation tends to raise the real interest rate (nominal rates minus the negative inflation), which discourages borrowing and further reduces demand. Expectations of even lower prices can cause people to postpone purchases and firms to delay projects, creating a downward spiral in spending and activity. This combination helps explain why deflation can be harmful to the macroeconomy in the short run. It’s not just a decrease in prices; it’s a persistent one that interacts with debt and expectations to slow the economy.