DEFLATION: ECONOMIC SIGNIFICANCE, CURRENT RISK,AND POLICY RESPONSES

CRAIG K. ELWELL

P. From 1-10Mahmood Al shammari

8-30-2010

The paper includes:

Background

Deflation Caused by a Negative Demand Shock

Deflation Caused by a Positive Supply Shock

The Current Risk of Deflation in the United States

Policy Responses to Deflation

Background :

Since mid-2009, the economy has been on a path of economic recovery. The economic growth during recovery has been slow.

The risk of deflation remains significant and could be a potential threat to achieving sustained economic recovery.

Deflation is a persistent decline in the overall level of prices.

Deflation occurs when price declines are so widespread and sustained that they cause a (CPI), to decline for several quarters, in a weak economy it can lead to a damaging self-reinforcing downward spiral of prices and economic activity.

Financial crises tend to be deflationary because :

Increased economic uncertainty increases the demand for cash by banks and financial institutions, constricting the flow of credit to households and businesses and dampening their spending.

It will exert downward pressure on the current price level, households and businesses may come to expect the future price level to also fall.

A self - reinforcing dynamic could be set in motion that will amplify the decline of prices and output.

Example of deflation’s harmful effect on economic activity was the United States in the Great Depression of the 1930s.

Example of kind deflations when economic activity expanded despite a falling price level:

- U.S.A, from 1880 -1896. - China, from 1998 through 2003.

The force generating the falling price level is collapsing (AD) or accelerating (AS).

Deflation from a Negative Demand Shock Hurts Economic Activity

This deflation can dampen economic activity through : -wages, a falling price level will increase the “real”

cost of inputs, raising the unit cost of production, causes firms to reduce production and employment.

-It will tend to increase “real” interest rates,

dampening credit-supported economic activity. ( r=i-f ) -It will increase the real debt burden of businesses

and households, repaying the loan principal with dollars of rising real value, falling asset prices, collateral is losing value.

International Transmission of Deflation

Occur in a system of fixed international exchange rates, such as under the gold standard in the 1920s and 1930s.

Trade imbalances caused gold outflows from countries with trade deficits and gold inflows to countries with trade surpluses.

The change in relative prices of foreign and domestic goods would then work to correct the trade imbalance and stop the flow of gold.

Central banks would intervene, deficit country reducing the money supply and raising interest rates to slow the economy, push down the price level, and improve the competitiveness of domestic goods.

International transmission of deflation is less likely within a regime of flexible exchange rates, as used by the U.S and most major economies today, because it allows independent policy action.

Because of the stimulus to total spending generated by the improved terms of trade, the overall deflationary impact in the U.S tended to be modest. 

The Role of Expectations

- The expectation of further deflation can create a self-reinforcing downward spiral.

- Government would need to convince economic agents to expect inflation rather than deflation.

Deflation Caused by a Positive Supply Shock is More Benign

It increase the level of output, offsetting the negative effects of the deflation.

Decline in output prices is countered by a productivity-induced decline in the per-unit cost of production.

Increased productivity tends to increase real interest rates, which provides an offset to the downward pressure on nominal interest rates and helps to prevent nominal rates from hitting the zero bound.

Deflation increasing real debt burdens are offset by increased real income.

 

The Current Risk of Deflation in the United States

In 2008 and 2009, the U.S. economy received a negative demand shock from the combined impact of the financial fallout from the full of the housing price bubble in 2006 and a sharp cyclical downturn of the economy beginning in late 2007 that continued through mid- 2009.

With the return of economic growth, the price level stabilized and began to rise again, up about 1.0% through the first quarter of 2010.

Through June 2010 the CPI has fallen slightly.

Several indicators can be used to assess the risk of deflation:

1- Aggregate Price Behavior

A steady fall of the aggregate price level as evidenced by movement in the CPI or (PPI) is the clearest and most direct indicator of disinflationary pressure in the economy.

For the 12 months ending in June 2010, the CPI increased 1.1%, down from 2.0% in May 2010 and 2.7% in January 2010.

For the 12 months ending in June 2010, the core inflation rate is 0.9% the lowest rate of increase in 44 years, It decelerated further to 0.4%.

The (PPI) for the 12 months ending in June 2010 increased 2.7%, down from 5.1% in May and 6.1% in March.

For the 12 months ending June 2010, the “core” PPI for finished goods, which excludes food and energy prices, increased a more modest 1.0%.

2-Size of Output Gap

In mid 2009 it was 7.0%, economic recovery narrowed the output gap to an estimated 6.0%.

It may continue to exert sizable downward pressure on the price level.

3-Asset Price Behavior

Most asset prices fell sharply during the economic collapse of 2008 and 2009.

The stock and bond prices have rebounded. Dow Jones was near 6500 in March 2009 but has risen to over 10,000 since then.

household net worth, by the end of 2009, fallen $10 trillion below its level in 2007. Tending to weaken AD and slow economic growth.

4-Exchange Rate Behavior

During the last half of 2008 and the first quarter of 2009, the dollar appreciated as foreign investors increased their demand for U.S.(T.secu).

Dollar depreciated during the remainder of 2009.

Over the first six months of 2010, the dollar appreciated about 5.0%. Because of the sovereign debt problems in the euro area.

Demand for low-risk dollar assets has strengthened again.

An appreciating dollar will decrease the domestic price of imported goods and exert downward pressure on the price level.

Global “flight to quality” keep the demand for U.S. (T. secu) strong.

5-Monetary Aggregates and Bank Reserves

Households hold cash rather than spend and financial institutions attempt to increase liquidity and accumulate excess reserves rather than lend.

It will decrease the money supply and exert more downward pressure on economic activity and prices.

For the 12 months ending in June 2009, the money stock measure M2 increased 9.2%.

For the 12 months ending in June 2010, M2 has increased only 1.8%.

This could be the result of higher demand for cash by households and a diminished willingness of banks for lending.

low rate of money supply growth could be deflationary.

6-Proximity to Zero Bound

If nominal interest rates are at or near zero, deflation will increase real interest rates and dampen interest-sensitive spending.

It creates an economic environment in which the negative effects of deflation on economic activity can be sharply amplified.

7-Price Level Expectations of Investors

If the nominal rate on the (T.secu) is higher than the inflation-indexed rate, investors are thought to be expecting inflation as measured by the premium of the nominal rate over the inflation-indexed rate.

So far, however, broad-based price indexes show a deceleration of inflation but do not reveal the presence of deflation.

Recently, estimates of inflation expectations have moderated, but they still remain positive.