How does inflation and deflation affect economic growth

Prolonged periods of deflation can stunt economic growth and increase unemployment. Japan's "Lost Decade" is a recent example of the negative effects of deflation. Just as out-of-control hyperinflation is bad, uncontrolled price declines can lead to damaging a deflationary spiral.

Inflation affects growth by changing the labor supply and demand, and thus reducing aggregate employment in the sector that is subject to increasing returns. The reduction in the level of employment will reduce the marginal productivity of capital.

If deflation is exacerbated, it can throw an economy into a deflationary spiral. This happens when price decreases lead to lower production levels, which, in turn, leads to lower wages, which leads to lower demand by businesses and consumers, which lead to further decreases in prices.

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