Deflation
Prevention and Cure
Willem Buiter
Chief Economist
19 May 2003
Introduction



It’s baaaaack!
Definition: sustained decline in cost of living;
persistent negative inflation of price index for
current goods and services. Practical examples:
RPI, RPIX, RPIY, CPI, HICP, GDP deflator, private
consumption deflator in the GDP index.
Asset price deflation; important, but not ‘deflation’
as used in this lecture.
Why worry about deflation?
• (Alleged) historical association of deflation with
financial crises, recession, stagnation and
depression. Debt deflation and the Great
Depression.
• (Short) nominal interest rates at zero (‘zero lower
bound problem’); liquidity trap – monetary policy
cannot stimulate demand.
• But: Bailey & Friedman’s optimal monetary rule:
zero nominal interest rate. If real interest rate
positive, deflation is optimal.
Why the concern today? A little history
• Japan: BoJ discount rate at 50bps or less since 1995;
now near zero; slump since 1992, GPD deflator has fallen
in each of past 5 years; CPI and money wages have fallen
in 4 out of past 5 years.
1950
1951
1952
1953
1954
1955
1956
1957
1958
1959
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
30
1950
1951
1952
1953
1954
1955
1956
1957
1958
1959
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
Japan
(%)
25
20
15
10
5
0
-5
Sources: UN Common Database and European Commission.
Real GDP Growth (%)
Sources: UN Common Database and Bloomberg.
Short-term Interest Rate
CPI Inflation (%)
(%)
Long-term Interest Rate
Money Wage Growth (%)
20
(1950 = 100)
3,500
18
16
3,000
14
2,500
12
10
2,000
8
1,500
6
4
1,000
2
500
0
0
Equity Index (TOPIX, deflated by CPI, 1950=100, Second Axis)
• European Union: ECB’s repo rate at 2.5%;
HICP inflation for 2002 2.2%; real economy
faltering; euro strongest since introduction
4½ years ago.
20
(%)
1950
1951
1952
1953
1954
1955
1956
1957
1958
1959
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
European Union
30
(%)
25
20
15
10
5
0
-5
Sources: IMF and European Commission.
Real GDP Growth (%)
Short-term Interest Rate
CPI Inflation (%)
Long-term Interest Rate
Sources: UN Common Database, Bundes Bank and Bloomberg.
Money Wage Growth (%)
(1959 = 100)
500
18
450
16
400
14
350
12
300
10
250
8
200
6
150
4
100
2
50
0
0
Equity Index (DAX, deflated by CPI, 1976=100, Second Axis)
• USA: Federal Funds rate at 1.25%; real
economy ‘soggy’ (Snow). CPI inflation 1.9%
for 2002, PCE (personal consumption
expenditures deflator) inflation1.9%.
1950
1951
1952
1953
1954
1955
1956
1957
1958
1959
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
1950
1951
1952
1953
1954
1955
1956
1957
1958
1959
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
USA
30
(%)
25
20
15
10
5
0
-5
(%) Sources: UN Common Database and European Commission.
Real GDP Growth (%)
Short-term Interest Rate
CPI Inflation (%)
Sources: UN Common Database, Federal Funds and Bloomberg.
Long-term Interest Rate
Money Wage Growth (%)
20
(1950 = 100)
500
18
450
16
400
14
350
12
300
10
250
8
200
6
150
4
100
2
50
0
0
Equity Index (S&P 500, deflated by CPI, 1950=100, Second Axis)
• UK: Bank of England’s repo rate at 3.75%; For
2002: HICP inflation at 1.6%; GDP deflator at
3.2%; RPIX at 2.2%; Dec. 2002 at 1.9%, January
2003 at 2.6%, March 2003 at 3.0% (RPI at 3.1%);
Sterling weakening; Real economy sluggish.
1950
1951
1952
1953
1954
1955
1956
1957
1958
1959
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
1950
1951
1952
1953
1954
1955
1956
1957
1958
1959
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
UK
30
(%)
25
20
15
10
5
0
-5
(%) Sources: UN Common Database, Wolfbane Cybernetic and European Commission.
Real GDP Growth (%)
Short-term Interest Rate
RPI Inflation (%)
Sources: UN Common Database, Bank of England and Bloomberg.
Long-term Interest Rate
Money Wage Growth (%)
20
(1984 = 100)
400
18
16
350
14
300
12
250
10
200
8
150
6
4
100
2
50
0
0
Equity Index (FTSE, deflated by RPI, 1976=100, Second Axis)
UK 1800-1914: inflation highly volatile;
average inflation rate negative
20
15
10
5
0
-5
-10
-15
-20
-25
1800 18061812 1818 18241830 18361842 1848 18541860 1866 18721878 18841890 1896 19021908 1914
RPI
RPI (annual % change)
Bank rate never below 2%.
Per cent
US dollar
15
11
Inflation (1hs)
Bank rate (1hs)
10
10
5
9
0
8
-5
7
-10
-15
£/$ exchange
rate (rhs)
-20
1817 1827 1837 1847 1857 1867 1877 1887 1897 1907
6
5
4
Good Deflation and Bad Deflation (Bordo
and Redish [2003])?
• Good deflations: positive supply shocks cause potential
real output to grow faster than nominal aggregate
demand. Characterised by rising employment and output
growth, high profits and booming stock markets. E.g. mild
deflation during 1870 - 1896 accompanied by positive
growth in many countries. However, growth accelerated
during period of inflation after 1896.
• Bad deflations: negative shocks to aggregate demand
cause nominal demand growth to fall below the growth
rate of potential real output. Characterised by falling
employment and output growth, low profits and falling
stock markets (1919-1921, 1929-1933, Japan 1995 -).
Is deflation just inflation with the sign reversed?
Are anti-deflationary policies just anti-inflationary
policies with the sign reversed?
• Symmetries:
1.
2.
•
Menu costs
Shoe-leather costs: anticipated inflation (deflation) raises (reduces)
opportunity cost of holding money if nominal interest rate adjusts onefor-one with expected inflation.
Asymmetries:
1.
2.
Zero lower bound on risk-free nominal interest rates
Unanticipated inflation redistributes from (non-index linked) creditors to
debtors. Unanticipated deflation redistributes from (non-index linked) debtors
to creditors. No counterpart in inflation case to default, bankruptcy and painful
financial restructuring often found in the deflation case (debt deflation).
3.
Asymmetries in upward & downward nominal wage and price adjustment
4.
Unfamiliarity (outside Japan) with deflation in living memory.
Why don’t we see negative nominal interest
rates?
i-iM
•
Opportunity cost of holding base money:
i
short nominal interest on non-monetary security
iM nominal interest rate on base money
•
Bearer securities vs. registered securities
•
Monetary base:
•
–
bank reserves are registered securities
–
Currency is a bearer security
A ’carry tax’ on currency: Gesell’s Proposal.
Do asymmetric downward nominal price and wage
rigidities make deflation particularly costly?

No nominal rigidities (either up or down) in asset markets.

In UK, with persistence of low inflation during past decade,
price cuts for goods becoming common: UK, 2002 year to
August, CPI inflation at 1.9%; CPI goods inflation at -1.1%;
CPI services inflation at 4.6% (King [2002]).

Wages: Nickell and Quintini [2003] using micro-data find
evidence of statistically significant but small nominal
rigidities (spike at zero in density function of money wage
contract changes at zero). Note: no evidence for or against
asymmetry.

In inflationary world, resistance to a nominal wage cut is a
necessary part of resistance to real wage cut. ‘Fairness’
concerns relative real wages.
Can we disentangle monetary and fiscal
policy? Should we care?

4 potential monetary instruments
– Conventional

Short nominal interest rate on non-monetary securities

Stock of base money

Nominal spot exchange rate
Note: of 3 conventional monetary instruments, only one can be
independently selected by monetary authority under unrestricted
international financial capital mobility.
– Unconventional

Nominal interest rate on base money

Monetary Policy: any change in one or more of the
4 monetary policy instruments that, at given prices
and activity levels, leaves unchanged financial net
worth of state, now or in future (state =
consolidated general government & central bank).

Fiscal policy: any change in public spending or tax
rules, whether or not they alter, at given prices and
activity levels, financial net worth of state, now or
in future.

How to avoid deflation or how to escape from
deflation once you’re landed in it. Amounts to
question: how can monetary and fiscal policy boost
aggregate demand.

Pedantic precision: how can monetary and fiscal
policy boost aggregate demand at given (current
and future expected) prices & wages, given current
and future nominal exchange rates, given current
and future expected employment and output levels.
(1)
DH = CH + IH + GH + X
DH : Aggregate demand for domestic output
CH : Private consumption demand for domestic output
IH :
Private investment demand for domestic output
GH : Government spending on domestic output
X:
Export demand

Share of private consumption of domestic output in
total private consumption depends on the relative
price of imports and domestic goods

Same for private investment spending on domestic
output and government spending on domestic
output.

Total private consumption is the sum of
consumption by ‘Keynesian’ consumers who
spend their current disposable income and
consumption by ‘permanent income’ consumers,
who smooth consumption over the life-cycle.


Aggregate consumption, C, is sum of the consumption
of the permanent income consumers and the
Keynesian consumers.
Share σ of consumers is Keynesian. The wage bill is W
and labour income taxes is T.

(2)

Consumption by permanent income consumers is
product of marginal propensity to spend out of
comprehensive wealth, μ, and comprehensive wealth,
sum of financial wealth, A, and its share 1-σ , of human
wealth, H.
C=µ[A+(1- σ)H]+ σ(W-T)

Financial wealth, A, includes stock market wealth,
present discounted value of future profits.

Human wealth, H, is present discounted value of
current and future after-tax labour income.

Private investment also depends on present
discounted value of future profits (‘Tobin’s q’)
Monetary Policy

Until further notice, assume interest rate on base money
(currency) is zero.

(1) Cut in current short nominal interest rate (consider
effect on demand at constant exchange rate).
1.
Effect on investment through Tobin’s q. Other mechanisms: credit
channel; bank lending channel.
2.
Effect on consumption through
1.
Substitution effect
2.
Income effect
3.
Valuation effect.
Substitution and income effects work through μ.
Valuation effect works through A (stock market) and through H.
Significant effect on μ unlikely (could be negative!).
Any positive effect likely to be small (μ is small).

(2) Credible announcements of future cuts in nominal
interest rates (can be associated with (1)).

(3) Devaluation (consider effect on demand at given
current and future nominal interest rates). MarshallLerner conditions; expansionary effect strengthened if
country is net foreign currency creditor.

(4) Unconventional monetary policy when short nominal
interest rates are zero.

(a) Generalised open market operations
– Purchases of any government securities with positive nominal
interest rate
– Sterilised foreign exchange purchases
– Purchases of other foreign currency assets
– Purchases of private domestic securities or real assets (stocks,
bonds, options, other derivatives, property).
– Easing of eligibility requirements for securities acceptable as
collateral in repo operations. Expand list of eligible couterparties.
Problems: moral hazard, adverse selection, governance.

(b) Spitting in the wind: introducing an inflation target or
raising an existing one when you’re flat on the floor.

(c) Negative nominal interest rates through a carry tax on
currency.

Fiscal policies to stimulate aggregate demand
– (1) Debt-financed (lump-sum) tax cuts

(A) With Keynesian consumers

(B) With permanent income consumers only
– (a) Without Ricardian equivalence (debt neutrality)
– (b) With Ricardian equivalence
– (2) Temporary increase in public spending on domestic
output, financed any which way.
– (3) The fail-safe policy: Friedman’s helicopter drop of
money.
Equivalent to tax cut (or increase in government
transfer payments) financed by printing base money.
– (4) Feldstein’s proposal: use current indirect tax cuts
and future indirect tax increases to tilt intertemporal
terms of trade in favour of current consumption.
Similar to temporary investment tax credit or temporary
investment subsidy.
Tackling deflation: how much can the
central bank do on its own?

Open market operations. May need help from
Treasury to do the unconventional stuff.

Can Central Bank perform helicopter drop of
money on its own? Central Bank is not fiscal
agent. Requires Treasury assistance (tax cut or
transfer payment financed through Treasury
borrowing, either directly from Central Bank or
indirectly, with Treasury borrowing in market and
Central Bank buying Treasury debt in market.
Conclusion

There is no excuse for persistent unwanted
deflation. Deflation can be avoided. If it has
taken hold, deflation can be eradicated.

Ending unwanted deflation is technically trivial
and politically attractive: tax cuts and/or spending
increases.


Inflation is always and everywhere a monetary
phenomenon (Friedman)
… and the price of bananas is always and
everywhere a banana phenomenon (Mrs. Mildred
Smith from Tooting Bec)

Money is always and everywhere a fiscal
phenomenon (Sargent and Wallace).

Excessive, inflationary budget deficits are the
reflection of unresolved social conflict (Joachim
Marx).
Final Reflections

Unwanted, persistent deflation is always and
everywhere evidence of unnecessary, avoidable
macroeconomic mismanagement (including failure
to coordinate monetary and fiscal policy).

It is not believable that governments have
forgotten easy mechanics & attractive politics of
boosting inflation/eliminating unwanted deflation.