IWS Documented News INTERNATIONAL

IWS Documented News Service
_______________________________
Institute for Workplace Studies----------------- Professor Samuel B. Bacharach
School of Industrial & Labor Relations-------- Director, Institute for Workplace Studies
Cornell University
16 East 34th Street, 4th floor---------------------- Stuart Basefsky
New York, NY 10016 -------------------------------Director, IWS News Bureau
________________________________________________________________________

 

Congressional Research Service (CRS)

 

Deflation: Economic Significance, Current Risk, and Policy Responses

Craig K. Elwell, Specialist in Macroeconomic Policy

August 30, 2010

http://opencrs.com/document/R40512/2010-08-30/download/1013/

[full-text, 19 pages]

 

Summary

Despite the severity of the recent financial crisis and recession, the U.S. economy has so far

avoided falling into a deflationary spiral. Since mid-2009, the economy has been on a path of

economic recovery. However, the pace of economic growth during the recovery has been

relatively slow, and major economic weaknesses persist. In this economic environment, the risk

of deflation remains significant and could delay sustained economic recovery.

 

Deflation is a persistent decline in the overall level of prices. It is not unusual for prices to fall in

a particular sector because of rising productivity, falling costs, or weak demand relative to the

wider economy. In contrast, deflation occurs when price declines are so widespread and sustained

that they cause a broad-based price index, such as the Consumer Price Index (CPI), to decline for

several quarters. Such a continuous decline in the price level is more troublesome, because in a

weak or contracting economy it can lead to a damaging self-reinforcing downward spiral of prices

and economic activity.

 

However, there are also examples of relatively benign deflations when economic activity

expanded despite a falling price level. For instance, from 1880 through 1896, the U.S. price level

fell about 30%, but this coincided with a period of strong economic growth. Whether a deflation

is on balance malign or benign most often will hinge on whether the force generating the falling

price level is collapsing aggregate demand or accelerating aggregate supply. Both forces exert

downward pressure on the price level but have opposite effects on the level of economic activity.

 

Deflation can dampen economic activity through several channels. First, a falling price level will

increase the real (inflation adjusted) cost of inputs, raising the unit cost of production. Second,

when nominal interest rates are low, as they are now, deflation could increase real interest rates,

dampening credit-supported economic activity. Third, deflation will increase the real debt burden

of businesses and households that already hold debt because they will be repaying the loan

principal with dollars of rising purchasing power.

 

The expectations of households and businesses about the future path of the price level will

influence deflation’s persistence and the difficulty of stabilizing the falling price level. The

expectation of further deflation can create a self-reinforcing downward spiral that deepens and

prolongs the fall of economic activity as households and businesses adjust their economic

outlooks. To avoid that outcome, government would likely need to take policy actions that not

only counter the current negative demand shock and constricted flow of credit to the economy,

but also create the expectation among economic agents that the future price level will be higher

than the current price level; in other words, government would need to convince economic agents

to expect inflation rather than deflation.

 

Economic policy can in theory contain or mitigate the negative effects of a deflation caused by a

negative demand shock. The conventional macroeconomic policy tools of monetary and fiscal

policies could be used to support current aggregate spending and exert upward pressure on the

price level. Also, greater use of the Federal Reserve’s (Fed’s) traditional role of “lender of last

resort” can be used to reduce any deflation-induced constriction of the flow of credit that could be

dampening spending by households and businesses.

 

Contents

Background ...............................................................................................................................1

Deflation from a Negative Demand Shock Hurts Economic Activity ...........................................2

International Transmission of Deflation.................................................................................4

The Role of Expectations ......................................................................................................4

Deflation Caused by a Positive Supply Shock is More Benign.....................................................5

The Current Risk of Deflation in the United States ......................................................................5

Aggregate Price Behavior .....................................................................................................6

Size of Output Gap................................................................................................................7

Asset Price Behavior .............................................................................................................7

Exchange Rate Behavior .......................................................................................................8

Monetary Aggregates and Bank Reserves ..............................................................................8

Proximity to Zero Bound.......................................................................................................9

Price Level Expectations of Investors....................................................................................9

Overall Risk of Deflation ......................................................................................................9

Policy Responses to Deflation...................................................................................................10

Macroeconomic Policy........................................................................................................10

Monetary Policy............................................................................................................10

The Fed as Lender of Last Resort ..................................................................................13

Fiscal Policy .................................................................................................................14

Conclusion...............................................................................................................................15

Contacts

Author Contact Information ......................................................................................................16

________________________________________________________________________

This information is provided to subscribers, friends, faculty, students and alumni of the School of Industrial & Labor Relations (ILR). It is a service of the Institute for Workplace Studies (IWS) in New York City. Stuart Basefsky is responsible for the selection of the contents which is intended to keep researchers, companies, workers, and governments aware of the latest information related to ILR disciplines as it becomes available for the purposes of research, understanding and debate. The content does not reflect the opinions or positions of Cornell University, the School of Industrial & Labor Relations, or that of Mr. Basefsky and should not be construed as such. The service is unique in that it provides the original source documentation, via links, behind the news and research of the day. Use of the information provided is unrestricted. However, it is requested that users acknowledge that the information was found via the IWS Documented News Service.

****************************************
Stuart Basefsky                   
Director, IWS News Bureau                
Institute for Workplace Studies 
Cornell/ILR School                        
16 E. 34th Street, 4th Floor             
New York, NY 10016                        
                                   
Telephone: (607) 255-2703                
Fax: (607) 255-9641                       
E-mail: smb6@cornell.edu                  
****************************************