Economics

The Great Depression taught us that falling prices or deflation and inflation are both destructive to the economy. Sustain fall in prices reduces incentives for businesses to increase production. The implication businesses will either cut available working hours or lay off some of its workers. Because wages tend to be inflexible in the short-run, the economy suffers from sustained recession (or depression).

Sustained double-digit inflation can weaken the economy. Rising prices adversely affects the input-output mix of the production process. If the prices of inputs increase considerably, then the prices of final goods increase proportionally. Because wages are inflexible in the short-run, real income will correspond to low-purchasing power. Inflation was generally absent during the Depression Era because of sustained fall in prices. However, during periods of recovery inflation is an issue. Single-digit inflation means that the economy is growing whilst a double-digit inflation means that the economy is in a state of shock. Now, central banks should ensure that interest rate will result in single-digit inflation.

There is a monetary aspect in the study of the Great Depression. During the Great Depression, deflation left the value of loans untouched, eroded the value of collateral, and shrank the borrowers equity. Wages can adjust to falling prices, but debts cannot because interest rates cannot go below zero. What should central banks do when deflation is sustained Central banks should ensure that the supply of money in an economy is sufficient to cover collateral and preserve borrowers equity. A relatively low supply of money in an economy results to short-term decrease in prices a relatively high supply of money in an economy results to short-term increase in prices. The Great Depression taught us that central banks should increase the supply of money when the economy is in recession and decrease the supply when the economy is recovering.