Our friend jk over at Three Sources laments:
While I’m willing to defend all the Fed’s actions to date as protection from deflationary shocks, I’ll join Mr. Kudlow in suggesting no further cuts.
Not to pick on jk (as it is not clear from the post whether he fears deflation from world economic growth, excess demand for money, or both), but deflation gets a bad rap — as it should in some cases. Deflation, however, is not all bad. Rather it depends on the cause of deflation.
There is a stark difference between what we will call benign and malign deflation*. Benign is deflation that is caused by an increase in growth. Malign deflation on the other hand is that which is caused by an excess demand for money. In order to understand the difference, recall the equation of exchange:
MV = Py
where M is money, V is velocity, P is the price level, and y is real output. A productivity increase will lead to an increase and y and a decrease in P (for simplicity, we will assume that the changes are equal). The decrease in the price level is quite “natural” to economic growth as the change is not due to some monetary disturbance, but rather an increase in productivity. Additionally, real incomes rise without nominal wage adjustments. This is known as benign deflation and is perfectly healthy (and perhaps desirable) in a growing economy.
By contrast, consider a change in money demand (where money is understood as money holdings). In this case, people will tend to hold more money, which decreases velocity (V). If the central bank does not respond with a corresponding increase in money (M), the pressure falls on the right-hand side of the equation. Thus, there is downward pressure on nominal output (Py). This is known as malign deflation and is necessarily harmful to the economy. As individuals hold more money, they are forgoing potential purchases. This puts downward pressure on the price level. However, prices are sticky and therefore do not fall simultaneously, but rather they fall sequentially. Thus, the downward pressure on prices results in downward pressure on output in sectors where prices are relatively sticky. The result is a reduction in real output as well as a fall in the price level.
As should be obvious, the differences are stark. When deflation results as a consequence of economic growth, this fall in the price level is quite desirable. However, when deflation results due to a monetary shock or central bank mismanagement, the results can be quite startling.
This difference was recently traced by David Beckworth, who finds that in the postbellum United States, there is ample evidence of a difference between benign and malign deflation.
So fear not deflation — as long as it is the result of economic growth.
* This terminology is consistent with that used by Beckworth (2007) and others.