Deflation Isn’t All Bad

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.

4 responses to “Deflation Isn’t All Bad

  1. Pingback: Deflation…again « The Everyday Economist

  2. Pingback: Is Deflation on the Horizon? « The Everyday Economist

  3. Your characterization of deflation’s categories is overly simplistic, ignoring some very important points:

    The first is that natural price declines are not deflation.

    For example, price declines, from productivity improvement or increases in technology. These are good for the economy, including the producers.

    Actual deflation is a negative change in the ratio of money to economic wealth. This kind of money shortage is universally harmful.

    Second, you refer to deflation from economic growth as good, when in fact that is the kind that causes economic depressions. If the economy outgrows money supply, shifting the ratio, the downward pressure punishes investment of capital and ownership of private property, as well as both borrowing and lending, freezing the primary functions of capitalism. This was a key cause of the Long Depression, lasting for 23 years, starting in 1873, as well as the Great Depression, and a half dozen other economic depressions that occurred in the 19th and early 20th centuries.

    ALL actual deflation is bad, for the same reasons (but with different specifics) that all inflation is bad. The ideal situation is to not distort prices artificially at all, but have them change naturally, according to real supply and demand, instead of a change in the supply of and demand for money.

    http://butnowyouknow.wordpress.com/2008/12/16/why-deflation-is-badfor-you-private-property-and-capitalism/

    The economic depression we now appear to be suffering is a result of deflationary pressures, which cause bank runs, commodity price failure, credit shortage, and the other traits that we have not seen in the recessions of the last sixty years, until now.

  4. it is a common sense that we cannot put all the pressure on export . Therefor, if people keep the negative attitude on investment and consume , it will destroy a large number of companies , meanwhile it also bring a lot of people who lose their jobs .
    What if we put the financial problem on the export , it is not difficult to image how horrible it will when a coutry`s fate is controled by another countries.

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