Problem
Deflation is defined as a decrease in the general price level of goods and services, occurring when the inflation rate falls below 0%. The following passage from former Fed Chairman Bernanke explains some of the differences between a normal recession and a deflationary recession:
"However, a deflationary recession may differ in one respect from "normal" recessions in which the inflation rate is at least modestly positive: Deflation of sufficient magnitude may result in the nominal interest rate declining to zero or very close to zero. Once the nominal interest rate is at zero, no further downward adjustment in the rate can occur, since lenders generally will not accept a negative nominal interest rate when it is possible instead to hold cash. At this point, the nominal interest rate is said to have hit the "zero bound."
What are the main consequences of deflation for firms and households if the nominal interest rate hits zero? What would be the real interest rate in this case? Which other tools do Central Banks employ to address the threat of deflation?