Why Fear Deflation? A Tutorial

Economics for your Classroom from
Ed Dolan’s Econ Blog
Why Fear Deflation?
A Tutorial
Oct. 27, 2014
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to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like
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Deflation arrives in
Europe
 In December 2014,
inflation in the
Eurozone fell to -0.2
percent—far below
the ECB’s target of
+2%
 Twelve countries out
of 19 in the EZ had
negative inflation
 But why should
Europe—or anyone
else—fear deflation?
Jan. 16, 2015 Ed Dolan’s Econ Blog

What is Deflation?
 Deflation means a sustained
decrease in the average level of
prices as measured by a broad index
like the CPI
 A brief dip in the CPI for a month or
two does not count as deflation
 Sustained decreases in the price of
individual goods (say, flat-screen
TVs) do not count as deflation if the
average of all prices is increasing
 Japan is the country that has had the
most experience with deflation in
recent decades
The most recent country to experience
serious deflation was Japan, where the
consumer price index fell in 10 of 20
years between 1994 and 2013

But if inflation is bad, why isn’t deflation good?
 No one likes inflation. When we go
shopping, we always welcome low
prices—so why isn’t deflation good?
 Economists argue that both inflation and
deflation can interfere with the smooth
operation of the economy
 But before getting into the details, we
need to cover a few preliminaries . . .

Preliminaries (1): Real and nominal interest rates
 One key to understanding the effects
of inflation and deflation is the
distinction between nominal and real
interest rates
 The nominal interest rate is the rate
stated in the ordinary way, in dollars
of interest paid each year per dollar of
principal. That is how rates are stated
in loan contracts, advertisements, etc.
 The real interest rate is the nominal
interest rate minus the rate of inflation
Let . . .
R be the nominal interest rate
r be the real interest rate
p be the rate of inflation
Then . . .
r = R – p
Example: The nominal interest rate is
5 percent and inflation is 3 percent,
then the real interest rate is 5% – 3%
= 2%

Preliminaries (2): The real rate is the true cost of borrowing
The real interest rate measures the true
cost of borrowing and the true return from
lending because it takes into account any
change in the purchasing power of
money between the time a loan is made
and the time it is paid back
Example:
 I borrow $100 from you and agree
to repay $105 at the end of one
year, a nominal interest rate of 5
percent
 Inflation is 3 percent over the year
 The $105 you receive at the end
of the year will buy only as much
as $102 bought at the time the
loan was made, so in terms of real
purchasing power, your return
(and my cost) on the loan is 2
percent.

Preliminaries (3): The Fisher Principle
 By definition, the nominal rate of
interest is equal to the real rate of
interest plus the rate of inflation
 Other things being equal, the real rate
of interest will remain unchanged if
both borrowers and lenders both
expect a change in the rate of inflation
 According to the Fisher principle,
The nominal rate of interest will adjust
so that it is equal to the
(approximately constant) real rate plus
an inflation premium.
Example:
 In year 1, both borrowers and
lenders expect 3 percent inflation.
They agree to a nominal interest
rate of 5 percent, equal to a real
rate of 2 percent plus a inflation
premium of 3 percent
 In year 2, both parties expect
inflation to be 4 percent, so the
agreed nominal rate rises to 6
percent, equal to a real rate of 2
percent plus a 4 percent inflation
premium

Preliminaries (4): Zero Bound for Nominal Interest Rates
 Nominal interest rates for ordinary
borrowing and lending between
private parties cannot fall below zero,
a principle known as the zero interest
rate bound, or zero bound, for short
 The zero bound causes the Fisher
principle to break down during times
of rapid deflation
 Once the nominal rate hits the zero
bound, any further increase in the rate
of inflation causes the real interest
rate to rise
Example:
 Suppose the nominal rate R is 5%
and the real rate r is 2% when
inflation p is 3 percent
 If p falls to 0, R will fall to 2% and
r will stay at 2%
 If p falls to -2%, R will fall to 0 and
r will stay at 2%
 But if p falls to -3%, R stays at 0
so r rises to 3%, and it will keep
on rising if the rate of deflation
continues to accelerate

A Common but Weak Reason to Fear Deflation
 Perhaps the most widely given reason to
fear deflation is that it might reduce
consumption
 The idea is that instead of buying a new
dishwasher now, people will wait a few
weeks or months in the hope that the
price goes down even more
 Reduced consumption spending, in turn,
could put the economy into a recession

The Flaw in the “Delayed Consumption” Fear
 The problem with the “delayed
consumption” argument is that it
normally pays to delay purchases,
whether prices are falling or rising
 As long as real interest rates are
positive, as the Fisher principle
predicts, waiting to make a purchase
is to your advantage because money
you leave in the bank earns interest
faster than inflation raises the prices
of the goods you buy
Example:
 You need a new dishwasher, priced at
$500 if you buy it today. With 2%
deflation, the price will fall to $490 if you
wait a year. The nominal rate of interest
on cash is 0% , which is as good as you
will get in a deflationary economy, so the
real return on savings is +2% . By waiting
a year, you will gain $10.
 Instead, suppose there is 3% inflation and
your bank is paying 5% nominal (2% real)
on a 1-year CD. Your dishwasher would
go up in price to $515 if you waited a
year, but your CD will be worth $525
when it matures, so waiting a year gives
you exactly the same $10 net gain.

Now for the serious reasons to fear deflation
1. Deflation is harmful banking, credit, and
financial markets
2. Deflation reduces the effectiveness of
monetary policy
3. Deflation brings turmoil to labor markets

The Zero Bound, Deflation, and the Cost of Borrowing
 A more serious potential problem
with deflation is that once nominal
interest rates hit the zero bound,
any increase in the rate of deflation
raises the real interest rate.
 As interest rates rise, people are
reluctant to borrow, so investment,
construction, and consumer
durable sectors slow down

Unexpected Deflation and Loan Losses
 Suppose a bank makes a loan at a
nominal rate of 5% when expected
inflation is 3%--a real rate of 2%
 Instead, we get deflation of 3%.
 At first glace, that would seem good
since the real rate would rise to 8%
 In reality, though, deflation might
deprive the borrower of income needed
to pay to loan, leading to a default
 The value of the collateral would be
less than the balance on the loan,
causing the bank to suffer a loss
 A spreading banking crisis could
weaken the whole economy

Deflation and Monetary Policy
 Deflation makes it difficult to conduct
effective monetary policy
 Usually, the first tool that central banks use
to stimulate the economy is a cut in
nominal interest rates
 When interest rates hit the zero bound,
there is no way to cut them further, so the
central bank loses its most important
instrument of control over the economy

Hitting the zero interest rate bound
 At the first signs of the
global crisis in 2007, the
Fed began to cut its key
interest rate target, the
Federal Funds Rate
 By the end of 2008, the
rate was effectively at
zero so this tool ceased
to operate
 The European Central
Bank and Bank of Japan
have also reached the
zero bound

Quantitative Easing
 When interest rates are
at the zero bound,
central banks can try
another tool, quantitative
easing or QE
 QE means massive
purchases of bonds to
increase the monetary
base, which consists of
currency and bank
reserves
 A larger monetary base,
in turn, is supposed to
stimulate lending

But Does Quantitative Easing Really Work?
 But does QE really
work?
 As this graph shows, QE
in the US raised the
monetary base, but
there was little effect on
GDP
 The Bank of Japan has
tried QE with mixed
results
 The ECB is thinking
about QE but has not
yet tried it

Labor Market Problems
 Inflation and deflation have asymmetrical
effects on labor markets
 When prices rise, workers willingly accept
nominal wage increases to match inflation,
even if their real wage is unchanged
 When prices fall, workers resist nominal
wage cuts even if they only match deflation
 If unionized, wage escalator clauses
usually operate only up, not down
 If not unionized, workers see nominal wage
cuts as unfair and strike, quit, or sulk
 Resistance to nominal wage cuts means
real wages rise during deflation, leading to
higher unemployment and lower real output

Can deflation ever be good?
We have seen that there are strong reasons
to fear deflation . . . but can deflation ever be
good?

Three Weak Reasons to Welcome Deflation
 Claim #1: Deflation is
good because when
the cost of living falls,
we can buy more with
our money
 But: Persistent
deflation either drives
down wages, too, or if
it does not, rising real
wages during a slump
cause higher
unemployment
 Claim #2: Deflation
is good because low
interest rates
stimulate investment
 But: Deflation brings
low nominal interest
rates, but after they
fall to zero, real
interest rates rise,
which discourages
investment
 Claim #3: Deflation
is good because it
encourages saving
 But: Although
saving may be good
in the long run, more
saving and less
spending is harmful
when the economy
is already in a
deflationary slump. It
is all a matter of
timing.

The exception: Supply-side deflation
Demand-Side Deflation
 The classic deflationary spiral
begins with a collapse of demand
 Unemployment rises, output falls,
people can’t pay their debts, banks
fail
 All these effects rightly give
deflation a bad name
Supply-Side Deflation
 Instead, deflation can begin when
rapid increases in productivity drive
down costs
 As costs fall, prices also fall, but
rising productivity allows real wages
to rise even if nominal wages are
unchanged
 Real demand and output grow, jobs
are plentiful
 Deflation is not rapid enough to
push nominal interest rates to the
zero bound, so financial institutions
remain healthy

Has Supply-Side Deflation Ever Happened?
 During most of the 19th century,
gradual productivity-driven
deflation was the norm
 In both the US and the UK, the
price level was lower at the end of
the 19th century than at the
beginning
 Both economies grew, although
with occasional downturns
 Both countries experienced
another episode of supply-side
deflation with strong economic
growth in the 1920s

Today’s Deflation in Europe
 Recent deflation in Europe
combines demand-side and
supply-side elements
 Weak demand has been pulling
inflation down for months
 However, inflation would not
have turned negative without
the sharp drop in energy prices,
especially the price of imported
oil
 By itself, lower oil prices have a
favorable supply-side effect on
oil-importing economies

The Bottom Line
 Economists fear deflation because it
disturbs banking, monetary policy, and
labor markets
 A collapse of demand can set off a
deflationary spiral: As prices fall faster,
financial and labor markets weaken and
the central bank loses its ability to control
the situation
 In contrast, deflation caused by long-run
productivity growth or by temporary factors
like a drop in the price of imported oil is
less likely to have harmful effects
 Unfortunately, there is no easy way to turn
bad deflation into good deflation!

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