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Ed Dolan’s Econ Blog Why Fear Deflation? A Tutorial Oct. 27, 2014 Terms of Use: These slides are provided under Creative Commons License Attribution—Share Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishing.

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 Jan. 16, 2015 Ed Dolan’s Econ Blog 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 . . . Jan. 16, 2015 Ed Dolan’s Econ Blog

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 Jan. 16, 2015 Ed Dolan’s Econ Blog 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 Jan. 16, 2015 Ed Dolan’s Econ Blog 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. Jan. 16, 2015 Ed Dolan’s Econ Blog 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 Jan. 16, 2015 Ed Dolan’s Econ Blog 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 Jan. 16, 2015 Ed Dolan’s Econ Blog

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 Jan. 16, 2015 Ed Dolan’s Econ Blog 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 Jan. 16, 2015 Ed Dolan’s Econ Blog

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 Jan. 16, 2015 Ed Dolan’s Econ Blog

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 Jan. 16, 2015 Ed Dolan’s Econ Blog

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 Jan. 16, 2015 Ed Dolan’s Econ Blog

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 Jan. 16, 2015 Ed Dolan’s Econ Blog

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 Jan. 16, 2015 Ed Dolan’s Econ Blog

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 Jan. 16, 2015 Ed Dolan’s Econ Blog

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 Jan. 16, 2015 Ed Dolan’s Econ Blog

Can deflation ever be good?
We have seen that there are strong reasons to fear deflation . . . but can deflation ever be good? Jan. 16, 2015 Ed Dolan’s Econ Blog

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 Jan. 16, 2015 Ed Dolan’s Econ Blog  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 Jan. 16, 2015 Ed Dolan’s Econ Blog 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 Jan. 16, 2015 Ed Dolan’s Econ Blog

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 Jan. 16, 2015 Ed Dolan’s Econ Blog

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! Jan. 16, 2015 Ed Dolan’s Econ Blog

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