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Essay On Inflation And Deflation

Over the past year, producer prices have fallen throughout the advanced world; consumer prices have been falling for the last 6 months in France and Germany; in Japan wages have actually fallen 4 percent over the past year.

Until the recent crisis prices were falling in Brazil; they continue to fall in China and Hong Kong; they will probably soon be falling in a number of other developing countries.

Yet here we are, with deflation turning out to be a serious problem after all - and with policymakers finding that it is not as easy either to prevent or to reverse as we all thought. And because the answers are so hard to accept, deflation is indeed a real risk.

(This note should be viewed as a companion piece to my earlier writings on Japan, particularly Japan: still trapped , but this time tries to approach the problem more generically). The first considers the popular view that deflation is simply a product of world excess capacity, and the problems with that view.

In fact, the idea that governments have a hard time keeping their hands off the printing press has long been a staple of political economy; dozens of theoretical papers have argued that the temptation to engage in excessive money creation causes an inherent inflationary bias in fiat-money economies.

It is largely to combat that presumed bias that most of the world has accepted the notion that monetary policy should be conducted by an independent central bank, insulated from political influence - and has written into the charters of those central banks that they should seek price stability as their main, often only, goal. The purpose of this note is to argue that more or less conventional economic theory actually does suggest some answers to these questions - but that these answers fly in the face of conventional policy wisdom.

And if the AS curve turns out to put the economy in a liquidity trap, monetary policy will no longer be effective in fighting deflation.

The converse is also true: a change in the real economy always mandates changes in the ratio of two nominal variables; one must invoke some nominal mechanism to determine how the numerator and the denominator change.Then it is still true that an increase in M shifts the AD curve up - but it may not shift it to the right. It shows an AD curve that has a normal slope over some range, but that below some critical level of prices - which is to say, above some critical level of M/P - becomes vertical, because further increases in the real money supply have no further effect on real spending.An increase in the money supply, as illustrated by the shift from AD to AD', will shift the whole schedule up; but in the liquidity-trap range will not shift it to the right.To see why most economists have had a hard time taking this view seriously, consider the simple aggregate-supply aggregate-demand diagram ( Figure 1 ) that appears in virtually every principles text.What advocates of the simple excess capacity story seem to be saying is that the AS curve has shifted right, as illustrated in the figure.So far, none of these price declines looks anything like the massive deflation that accompanied the Great Depression.But the appearance of deflation as a widespread problem is disturbing, not only because of its immediate economic implications, but because until recently most economists - myself included - regarded sustained deflation as a fundamentally implausible prospect, something that should not be a concern.Thus a growth in aggregate supply normally increases real balances, M/P; but only if M does not grow sufficiently is the result a fall in P.So what is the sticky nominal variable that explains how changes in the real economy are translating into downward pressure on prices?Since the nominal rate is fixed, however, this can only be accomplished via a decline in the city's price level.But how do we make sense of seemingly inexorable deflationary pressures in economies without fixed exchange rates, like Japan?


  1. Aug 5, 2011. Abstract In the inflation-deflation debate, deflationists view credit as the most important factor affecting prices. As far as they are concerned, the.

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