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Published on: 11/3/2002
Last Visited: 7/17/2003
In a paper entitled Deflation: The New Threat?, Manmohan S. Kumar, an advisor in IMF's research department, said the potential for deflation to spread across the world is a cause for concern.
"Policymakers have the instruments to head it off and can do so, provided they act preemptively.Monetary policy should be able to avert deflationary expectations," he pointed out.
The opposite of inflation is deflation, which occurs when the general level of prices is falling.
Mr. Kumar said low inflation brings substantial benefits, for example, more efficient resource allocation and a reduction in uncertainty.
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Mr. Kumar said monetary easing may need to be complemented by a more stimulatory fiscal stance.
He also said it may be desirable to implement specific measures to boost returns on capital investment that would have dynamic gains while signaling authorities' commitment to preventing a generalized decline in prices.
The author said monetary policy faces additional challenges in a deflationary environment, especially when nominal interest rates have hit their floor.
He noted that when the nominal interest rate is zero, policy cannot lower interest rates any further through the conventional channel.
The problem may be complicated if the banking system is undergoing difficulties, increasing the burden on structural reforms.
"With deflation, banks' bad debts increase and are likely to reinforce the banks' unwillingness to take risks, curtailing provision of credit," Mr. Kumar said.
He added that there has been an increase in the vulnerability to deflation in several countries, while mild deflation has continued in others.
"Given the costs of deflation, it is important to implement preemptive policies to prevent deflation from setting in or, where it has already set in, to pursue aggressive policies to contain and eradicate deflation expectations," he added. >
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