Final answer:
During a deflationary period, the real interest rate effectively increases as money gains purchasing power. If the nominal rate is 7% but deflation is 2%, the real rate becomes 9%. This higher financial burden on borrowers can contribute to higher default rates and economic downturns.
Step-by-step explanation:
During a deflationary period, the real interest rates can be significantly impacted due to the change in the value of money. By definition, deflation occurs when the rate of inflation is negative, meaning that the general level of prices is falling – as a result, money gains more purchasing power. This can create an environment where nominal interest rates remain the same, but the real cost of borrowing increases, creating a higher real interest rate.
For example, if the nominal interest rate is 7% and there is deflation of 2%, then the real interest rate isn't 7% but actually 9%. This is because the lender would be receiving money back that is worth more than when it was originally lent out, due to the increased purchasing power of money during deflation. Therefore, an unexpected deflation can raise the real interest payments significantly for borrowers, resulting in a higher financial burden. When borrowers face higher real interest rates, they may default on loans at a higher rate, leading to potential losses for banks, a decrease in new loan issuance, a decline in aggregate demand, and potentially triggering a recession.