Understanding Deflation: Causes, Types, and Prevention, Exercises of Banking and Finance

Download Understanding Deflation: Causes, Types, and Prevention and more Exercises Banking and Finance in PDF only on Docsity! MONETARY BULLETIN 2003/1 1 The risk of deflation has come up for some discussion in Iceland. In part this is an echo of international dis- cussion on this issue, but it has also been inspired by the recent low rate of inflation. The CPI rose by only 1½% last year, and excluding its housing and service components the increase was a mere 0.3%. So what is deflation? What is the likelihood of it occurring in the industrialised countries? How can deflation be avoided and what is the most effective response if it occurs? The following is a brief attempt to answer these ques- tions. The most natural way to define deflation is in the same way as inflation, only in reverse. Inflation is defined as a persistent rise in the general level of prices. Thus a rise in the price of individual goods or a short-term rise in the price level is not considered to be inflation. Similarly, deflation is defined as a persistent decrease in the general level of prices. A decrease in the price level for a couple of months is not considered to be deflation, nor does a general reduction in the price of goods constitute deflation if the rise in the price of services is greater, whereby the price level does not rise on average. In fact it is not uncommon for a rise in the price of services to counterbalance a rise in the price of goods. In September 2002, consumer prices in the USA had risen by 1.5% from the year before. At the same time the price of services went up by 3.2% while the goods in the CPI went down by 0.9%. As a rule, productivity has increased more slowly in service industries than in manufacturing. However, if wages in different sectors rise in tandem due to intersectoral labour mobility, the price of services will inevitably increase by more than that of goods.1 In the same way that inflation occurs because of excess demand in the economy, deflation is the result of excess supply. Excess supply may form because of a supply shock, but serious deflation is most probable when a sharp contraction in demand creates a slack which causes prices and wages to fall. Such a scenario tends to go hand in hand with stagnation or recession and rising unemployment. Deflation may therefore be either benign or malignant. Benign deflation may be caused by growth in out- put and productivity or improved terms of trade. Examples are found in Britain and other countries dur- ing various periods of the nineteenth century, and even in China in recent years.2 Nonetheless, benign defla- tion is not entirely riskfree, because if external shocks occur under such conditions and call either for a tem- porary reduction in real wages or negative GDP growth, reluctance to reduce nominal wages and the fact that nominal interest rates can hardly drop below zero could cause unemployment to rise. Malignant deflation goes hand in hand with stag- nation or contraction and underutilised production capacity. This type of deflation may enter into a spiral with inadequate demand. In particular, this occurs if deflation expectations take root and the level of house- hold and corporate debt is high. In that case, real inter- est rates could become high even if nominal interest rates go down to zero, causing an increase in the debt service burden in real terms because liabilities carry fixed nominal rates of interest. Deflation therefore causes the real debt service burden to rise without any corresponding real appreciation of assets. This may have serious consequences for debtors, as shown in many instances, especially if asset prices fall. One example is the Great Depression of the 1930s when particularly malignant deflation occurred in many parts of the world and was amplified by a financial cri- sis, economic policy mistakes and protectionism. Other more recent examples of malignant deflation are Box 3 Deflation 1. Such a situation is not far-fetched. Let us take the example of an economy that comprises two sectors of equal size, goods manufac- turing and services. Let us also assume that productivity increases by 3% per year in goods manufacturing but remains unchanged in services. Average productivity would therefore increase by 1½% per year. Furthermore, let us say that real wages keep pace with the aver- age productivity trend plus 1%, which is reflected in a 1% rise in consumer prices. Nominal wages will therefore go up by 2½%. Because productivity in services remains unchanged, their price will increase by the same amount as wages. Goods prices, however, will decrease by ½% per year. This state is not deemed to be deflation. For simplification’s sake, this example ignores imported inputs and use of capital. The findings do not essentially change if these are included, but the figures would be different then and more complex to calculate. 2 MONETARY BULLETIN 2003/1 in China in recent years.2 Nonetheless, benign defla- tion is not entirely riskfree, because if external shocks occur under such conditions and call either for a tem- porary reduction in real wages or negative GDP growth, reluctance to reduce nominal wages and the fact that nominal interest rates can hardly drop below zero could cause unemployment to rise. Malignant deflation goes hand in hand with stag- nation or contraction and underutilised production capacity. This type of deflation may enter into a spiral with inadequate demand. In particular, this occurs if deflation expectations take root and the level of house- hold and corporate debt is high. In that case, real inter- est rates could become high even if nominal interest rates go down to zero, causing an increase in the debt service burden in real terms because liabilities carry fixed nominal rates of interest. Deflation therefore causes the real debt service burden to rise without any corresponding real appreciation of assets. This may have serious consequences for debtors, as shown in many instances, especially if asset prices fall. One example is the Great Depression of the 1930s when particularly malignant deflation occurred in many parts of the world and was amplified by a financial cri- sis, economic policy mistakes and protectionism. Other more recent examples of malignant deflation are Japan in the past few years and Argentina from 1999 to 2001. Because of its negative consequences, it is impor- tant to prevent deflation. A monetary policy that aims for price stability or a low rate of inflation can there- fore perform this function, by responding to negative demand shocks by monetary easing. There are at least three reasons to aim for a low rate of inflation rather than zero inflation. Firstly, changes in quality and composition of the CPI introduce a positive bias in the index. This bias is generally regarded to lie in the range ¼-1%.3 Observed inflation within this range therefore effectively corresponds to price stability. Another reason is that relative prices and real wages become less elastic at a very low rate of inflation, potentially causing an unnecessary loss of output and unemployment. The third reason is that modest infla- tion reduces the risk of the economy accidentally slip- ping into a deflationary spiral. However, moderation is called for in this respect, because inflation is also cost- ly for the economy. This is why it is commonly argued that central banks with inflation targets should target inflation not lower than 1% and not higher than 3%. What action can be taken if deflation becomes entrenched? Generally speaking the answer is to stim- ulate demand sufficiently to absorb any slack in the economy. In most cases this should be achievable through monetary policy. However, it may prove diffi- cult if central bank interest rates are already down to 1998 1999 2000 2001 2002 0.0 1.0 2.0 3.0 -1.0 -2.0 -3.0 -4.0 % Japan China Hong Kong Annual deflation in Japan, China and Hong Kong 1998-2002 Sources: EcoWin, Central Bank of Iceland. Annual inflation in USA, Germany and Switzerland 1998-2002 1998 1999 2000 2001 2002 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 % USA Germany Switzerland Change in consumer prices between years Change in consumer prices between years 3. Studies and discussions within the OECD have indicated a higher bias in the USA than in most European countries. CPI bias in Iceland has not been evaluated but it is considered to lie closer to the lower limit, e.g. because the index base is updated relatively frequently. 2. Pain and Weale (2002) cite the example of Britain between 1880 and 1890, when GDP grew on average by 2.2% annually at the same time as prices went down by 0.6% per year.