If the two fall rise and fall together – to the extent nominal interest rates can accommodate movements in nominal income growth – there’s no impact on debt accumulation: whatever proportion of income was needed to service debts beforehand is sufficient after the fact. It’s when income growth falls a lot further  1  Economists call the sensitivity of consumption to a change in its relative price over time the “inter-temporal elasticity”. That coefficient is poorly measured in the data but usually found to be relatively small and significantly less than one. At the same time, a permanent gain in real income should, even it’s expected to arrive only a year from now, prompt an immediate and almost one-for-one response of spending today. So, at least in principle, the positive “income effect” of a prospective drop in prices – holding fixed nominal pay – should be expected to outstrip the negative “inter-temporal substitution effect”. 2  If the appropriate real rate is r* then the central bank would ideally want to set a nominal rate of r*+ π , where the second term is inflation expectations. But nominal rates can’t be lower than zero – or whatever number, e close to zero, constitutes the effective lower bound – so if r*+ π < 0 the actual real rate will be higher than it should be. Note that this can happen either if πe is well below zero or if, as has been the case since the crisis, the same happens to r*.
BIS central bankers’ speeches  1  Following the financial crisis, of course, the developed world has been in exactly that position: the neutral real rate of interest has been extremely depressed, official interest rates have been pushed to the zero lower bound and central banks have employed unconventional means of easing monetary policy. Were it to occur right now, sustained deflation would therefore pose more of a risk than at times when the neutral real rate was higher. But, in my view, those risks are nonetheless relatively contained. For one thing I think the evidence suggests that unconventional policy is effective: even if they don’t circumvent it entirely, asset purchases help soften the constraint of the zero lower bound. Second, with the financial system gradually improving my guess is that the neutral real rate of interest is more likely to rise than fall over the next couple of years. Third, and most importantly, I think the chances of a sustained and widespread deflation are in any case low. That’s certainly what the international experience suggests. That experience is substantial: we have annual CPI data since 1960 for over 70 countries, a total of over 3,000 data points. In only 70 cases (barely 2% of the sample) have consumer prices actually fallen and in the majority of those inflation was positive the following year.