What happens to these lost Grin coins? Will they forever be frozen in the Blockchain as unspent coins?
Yes, they remain forever in the UTXO set. In this sense the UTXO set will grow proportionally in the number of transactions rather than the number of active participants.
amount of Grin in circulation will greatly increase?
Is that good or bad for Grin as a currency?
Neither, since multiplying emission by a constant has no effect on the economics.
Deflation being necessary for a medium to be useful as a store of value is unproven speculation.
Gold being the longest used form of store of value is the obvious counterexample (gold is inflationary). I believe the history of fiat shows that an exponentially increasing supply is the best form of currency.