Dr. Econ, what are the costs of deflation?
Thank you for asking such an interesting question! Although
I discussed deflation in my May
I did not cover the costs of deflation. It certainly is worthwhile
to revisit this important topic.
As you know, deflation is a decrease in the overall level
of prices. While concerns about inflation have tended to
dominate the minds of the public and policymakers in many
countries in recent years, deflation can be an equally serious
problem. When one thinks of deflation, Japan often comes
to mind because it recently experienced a particularly serious
bout of deflation. Only a few years ago, U.S inflation was
so low that many policymakers feared deflation would be a
serious possibility for the U.S. economy. Consider this quote
from a 2002 speech of then–Fed Governor (now Fed Chairman)
“With inflation rates now quite low in the United
States, however, some have expressed concern that we
may soon face a new problem—the danger of deflation,
prices. That this concern is not purely hypothetical
is brought home to us whenever we read newspaper reports
At first glance, deflation might sound like a good thing—who
would not like a world where things consumers buy get cheaper
over time? However, it is important to realize that in addition
to falling prices of goods and services, other prices would
be falling too. For instance, falling wages are likely to
accompany falling prices (since wages are the price of labor).
Should wages fail to adjust (as many economist believe can
happen, for reasons explained below), then jobs could be
lost as employers struggle to keep up with falling revenues.
As discussed by Fuhrer and Tootel (2004), the costs of deflation
can be separated into transition costs (moving from an inflationary
environment to a deflationary one) and steady state
costs (costs that arise once the transition takes place).
Transition Costs of Deflation
- Output Loss. Deflation is usually precipitated by
a weak economy. As Bernanke (2002) stated, “the sources
of deflation are not a mystery. Deflation is in almost
a side effect of a collapse of aggregate demand—a
drop in spending so severe that producers must cut prices
ongoing basis in order to find buyers.” Fuhrer and
Tootel (2004) estimate that in the U.S. the transition
from 2 percent inflation to 2 percent deflation would reduce
GDP by about 13 percent ($1.4 trillion). For comparison
purposes, in the third quarter of 2003 (the worst period
the 2001 recession), the economy shrunk by 1.4 percent,
at an annual rate.
- Reduced employment resulting from wage rigidity. It
is reasonable for producers who face lower prices of their
to cut wages too, to counteract the reduction in revenues
with a reduction in costs. However, when prices fall,
wages might not adjust instantaneously. If employers are
unable to lower wages, they might counteract the reduction
in revenue instead by restricting employment. This, in
turn, will lead to further output and income loss, because
is a major input into production.
- Arbitrary redistribution of wealth from borrowers
to lenders. Given that the experience of many countries
recent past has been that of steadily rising prices,
many long-term contracts are written with the expectation
inflation. Thus, when unanticipated deflation occurs,
these contracts need to be adjusted. It is reasonable to
that these adjustments will not be instantaneous, since
many contracts cover an extended period of time. Without
unexpected deflation will lead to arbitrary redistribution
of wealth from borrowers to lenders (the opposite of
the case of unanticipated inflation).
Steady-State Costs of Deflation
- Menu costs. Whether prices need to be revised up (as
in case of inflation) or down (in case of deflation),
there are costs to changing prices. Those costs include
price tags, updating computer systems, reprinting catalogs,
- Loss of government revenue. Since tax provisions are
based on nominal incomes, deflation may lead to a reduction
in tax rates even in case of no change to spending power
(Fuhrer and Tootel 2004).
- Costs to monetary policy. The tool of
many central banks (including the Fed) is short-term interest
funds rate in the case of U.S.).
Recall that periods of deflation are also periods of weak
economy. The “remedy” for
the weak economy would be lower nominal interest rates.
When we think about the link between interest rates and
we want to think about the real
the difference between the nominal interest rate and inflation.
When inflation is positive, it is possible for the central
bank to push real interest rates down (even below zero)
and stimulate investment spending and, perhaps, spending
goods. That, in turn, should boost overall output. However,
nominal interest rates cannot fall below zero. Therefore,
as the Japanese experience showed, in a situation with
deflation and a recession, the central bank may not be
able to push
real interest rates low enough to alleviate the situation.
Bank of Japan. 2003. “Japan's
Deflation and Policy Response.”
Bernanke, Ben. 2002. “Deflation: Making Sure "It" Doesn't
Happen Here.” Remarks Before the National
Economists Club, Washington, D.C.
English, William. 1996. “Inflation and Financial
Sector Size.” Board of Governors of the Federal
Reserve System, Finance and Economics Discussion Series. 96-1.
Fuhrer, Jeffrey and Geoffrey M.B.Tootell. “Issues
in economics: what is the cost of deflation?” 2004.
Federal Reserve Bank of Boston. Regional Review. Q 4 2003
/ Q1 2004, 2004 - p. 2-5.
Mankiw, Gregory. 2003. Macroeconomics, 5th edition. New
York, NY: Worth Publishers.
1 For learn more about monetary policy,
please see “U.S.
Monetary Policy: An Introduction.”