Occurs when the inflation rate is less than zero percent.

deflation occurs when inflation rate is less than zero percent

We always hear that inflation is bad for an economy, it is bad for people in general and imposes additional burden on the poor. Consequently we start believing that a negative rate of inflation, or deflation, is a good thing. It is not.

Explanation:

Here's why:

   Deflation is a disincentive to producers. Production process usually takes time. Some times there can be huge time difference between the time of placing order for raw material and selling the final product. In a deflationary economy, the prices of goods and services will keep falling during this time. Thus it will be very difficult for producers to make profits and their sale price may not be enough to cover the cost of raw materials.

   Deflation is disincentive to consumers. Think about it, if you have to buy a car, but you know that the car you want to buy will be available at a lower price some time in the future, would you still buy it? Thus in a deflationary economy, consumers tend to postpone their discretionary purchases (they have to buy essentials). This leads to pile up of inventory for producers creating further disincentive to producers.

The above two have a cyclical effect where the economy goes into a downward spiral. There is no production, hence no growth. Soon the economic machinery of the country could come to standstill.

This is the reason why central banks across the world target an inflation rate of around 2%. This is a manageable rate where the price increase are not high enough to hurt the consumers too much while the rate not being low enough to risk going into deflation.

It should be noted however that these consequences follow from a prolonged period of deflation. A month or two of deflation which quickly bounces back to inflation does not lead to such disastrous effects. Such deflation may be good to ease the pressure on the consumers. But central banks are wary, lest it get out of hand.

answer/// real gdp decreases to y3 and the price level falls to p3;