Would global deflation really be that bad?

The collapse in oil prices may only be a few months old, but economists are already debating its long-term effects: will the world be gripped in growth-sapping Japanese-style deflation or will the world economy benefit from a period of lower prices?

Deflation is classed as when consumer prices turn negative with the theory being that buyers would hold off from making purchases in the hope of further falls. This raises the fear of a prolonged deflationary spiral with the slump becoming so entrenched that it impacts growth and does little for the potential of wage increases.

The price of oil has seen a dramatic 40 percent fall since June and has weighed on headline inflation figures and is likely to continue to do so next year.

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Consultancy Capital Economics estimate that the energy component of inflation in advanced economies will fall temporarily to around minus 10 percent next year. Some consumers see little price reductions at the pump as their governments subsidize the commodity, but in the U.S. many have been cheering the drop in oil which has put more money in their pocket.

Bill Blain, a fixed income strategist at Mint Partners argues that lower oil prices does not necessarily translate into growth, however.

"Oil price declines are initially hailed as positive growth drivers – but in an already recessionary environment, perhaps they have become a soporific too far?," he said in a morning note on Friday.

"I am just not perceiving the global economy on the verge of a boom...the risks look to the downside – especially as the effects of lower oil are factored in."

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Consumer prices in November rose 0.3 percent for the euro zone, compared to the year before, and the European Central Bank has regularly downgraded its prospects for the next year as 2015 approaches. In the U.S., annual inflation still remains below the 2 percent goal given by the Federal Reserve. The Bank of England is expecting the U.K.'s inflation rate to fall below 1 percent next year and China's number currently sits at a five-year low.

'Baked in the cake'

Bethany Clarke | Getty Images

Economists at Capital Economics, fronted by their chief global analyst Julian Jessop, predict that the average inflation rate in the seven major advanced economies will fall only around 1 percent next year because of the oil price decline. It expects a growing number of economies to experience a period of outright deflation but then their outlook turns somewhat better.

"We expect global demand to expand at a moderate pace during the next two years," they said in a research note on Friday. "China's growth rate will probably slow further, but not collapse...a short period of deflation in fast-growing economies such as China would not pose a significant threat to growth prospects or to debt sustainability."

The fall in inflation is already "baked in the cake," according to the consultancy, adding that lower oil prices will drop out of the year-on-year comparisons in the second half of next year, meaning figures are likely to rebound.

Could China deflation spark a euro zone break-up?

Weak koruna helped us avoid deflation: Czech cental bank chief
Weak koruna helped us avoid deflation: Czech cental bank chief

Societe Generale's uber-bearish strategist Albert Edwards believes that investors are slowly waking up to the idea that the Chinese have a "major deflation problem" and its transition into a more consumer-led economy won't be a smooth one.

Traditionally the country is known for its cheap exports that compete strongly with domestically produced goods around the world. That model is unlikely to change soon, according to Edwards.

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"The realization that China will be exporting more deflation helps to explain why U.S. inflation expectations continue to plunge despite recent stronger than expected real economy data," he said in a note on Thursday.

He continues to warn that weakness in emerging markets could seriously impact Germany, the traditional powerhouse for the euro bloc. Germany sees China as one of the biggest buyers of its goods. Edwards said that Germany will eventually have to "walk the walk" and aggressively cut spending as it falls into recession next year.

"My own view is that the euro zone cannot withstand another full scale recession and will ultimately fracture despite the best efforts of the ECB," he said.