Thank you for asking such an interesting question! Although I discussed deflation in my May 2003 response, 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) Ben Bernanke:
“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, or falling prices. That this concern is not purely hypothetical is brought home to us whenever we read newspaper reports about Japan…”
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 all cases a side effect of a collapse of aggregate demand—a drop in spending so severe that producers must cut prices on an 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 annual GDP by about 13 percent ($1.4 trillion). For comparison purposes, in the third quarter of 2003 (the worst period following 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 goods 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 in fact 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 labor is a major input into production.
- Arbitrary redistribution of wealth from borrowers to lenders. Given that the experience of many countries in the recent past has been that of steadily rising prices, many long-term contracts are written with the expectation of continuing inflation. Thus, when unanticipated deflation occurs, these contracts need to be adjusted. It is reasonable to expect that these adjustments will not be instantaneous, since many contracts cover an extended period of time. Without adjustments, 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 changing price tags, updating computer systems, reprinting catalogs, etc.
- 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 rates (the fed funds rate in the case of U.S.1). 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 output, we want to think about the real interest rate, 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 on durable 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.