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On spending and borrowing

Some believe that, in the absence of large amounts of debt, deflation would be a welcome effect because the lowering of prices increases purchasing power. However, while an increase in the purchasing power of one's money benefits some, it amplifies the sting of debt for others: after a period of deflation, the payments to service a debt represent a larger amount of purchasing power than they did when the debt was first incurred. Consequently, deflation can be thought of as an effective increase in a loan's interest rate. If, as during the Great Depression in the United States, deflation averages 10% per year, even an interest-free loan is unattractive as it must be repaid with money worth 10% more each year.

Under normal conditions, most central banks, such as the Federal Reserve, implement policy by setting a target for a short-term interest rate – the overnight federal funds rate in the U.S. – and enforcing that target by buying and selling securities in open capital markets. When the short-term interest rate hits zero, the central bank can no longer ease policy by lowering its usual interest-rate target. With interest rates near zero, debt relief becomes an increasingly important tool in managing deflation.

In recent times, as loan terms have grown in length and loan financing (or leveraging) is common among many types of investments, the costs of deflation to borrowers has grown larger.