Final answer:
True, deflation happens when inflation rates are negative and money gains purchasing power. Deflation challenges monetary policy because the usual strategies to counteract a recession are less effective, and it can cause the real value of debt to increase.
Step-by-step explanation:
The statement that deflation occurs when the rate of inflation is negative is true. During episodes of deflation, money gains purchasing power over time, which is the opposite of what happens during inflation. An extreme example of deflation can be seen during the Great Depression when a sharp decline in consumer prices occurred, increasing the value of money.
Deflation can significantly challenge monetary policy because it makes the traditional tools for combating recession (like lowering interest rates) less effective. If the nominal interest rate is already low, there’s limited room to cut rates further to stimulate borrowing and spending.
Furthermore, when consumers expect prices to fall, they might delay purchases, leading to decreased demand, lower production, layoffs, and a deepening recession. Also, with deflation, the real value of debt increases, making it harder for borrowers to pay off their debts. This can lead to an increase in loan defaults and further stress on the financial system.