Last Updated 22 Jun 2020

Federal Reserve System

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This is usually in the aftermath of a boom accommodated by a big run up in debt, involving a large increase in capacity in response to very optimistic expectations about future sales and profits. When the optimistic expectations cannot be met, it is apparent that firms are over-invested and over-leveraged. They are then under pressure to shore up their balance sheets. Asset prices fall, as firms seek to disinvest.

Banks and other lenders find that the quality of their assets has deteriorated, and are tempted to reduce the flow of new credit in order to conserve their own capital. Aggregate demand in the economy declines, and prices for goods and services fall. This is the 'debt deflation' described by Irving Fisher many years ago. Depending on the size of the preceding boom, and on the policies pursued during the bust, this process can be exceedingly painful.

In the case where expectations of ongoing deflation become strongly held, moreover, it is possible that some fairly serious problems of economic management can emerge. Expectations that prices will continually fall may lead people to postpone spending, which of course amplify the deflationary pressure. The rate of deflation might, in extreme circumstances, also mean that attempts to boost growth by reducing interest rates run into the problem that the nominal interest rate cannot fall below zero, which might mean that the real interest rate is too high for the economy's needs.

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One could debate in each individual case what the proximate causes of this are, and whether it is 'good' deflation or bad. China's deflation is arguably a candidate to be classified as 'good' deflation, since it seems to be associated with rapid overall growth and rising living standards. Hong Kong's deflation is partly necessitated by the peg to the strong US dollar, though of the cumulative decline of about 13 per cent in Hong Kong's CPI since mid 1998, about half is due to declining rents, which is more associated with the decline in housing values after the earlier boom there. Of course, Hong Kong has an impressive capacity to adjust to these shocks, but even so it is a painful process. There is no doubt that Japan's deflation is of the bad kind.

Not the kind of mild temporary deflation which is a short-term period of economic weakness, but the kind of deflation which might itself be a cause of further economic weakness in future. The reason we so concerned is the possibility that it may not be easy to escape from such a situation. For instance an economy in which deflation is strongly expected to continue, at a rate which exceeds the natural real interest rate in the economy - that is the equilibrium return on real capital. In that situation, because nominal interest rates cannot fall below zero, the real interest rate set by the central bank cannot go below the natural rate.

Since conventional monetary policy works in an expansionary direction by lowering interest rates in the financial sector below the natural rate, it follows that conventional monetary policy is rendered incapable of applying stimulus to an economy in this situation. The real interest rate is too high, which means that policy remains too prolonging the deflationary pressure. There is a 'deflation trap', or a 'liquidity trap'.

Some have argued that this is the right diagnosis of Japan's situation. The question is: how likely is it that other countries will get into this sort of problem? It is less likely to occur in most of the other more dynamic economies of Asia. These countries must have tremendous opportunities for profitable investment in future. On that assumption, the natural interest rate is almost certainly much higher than the present or likely future rate of deflation. So while deflation or very low inflation in these countries is probably a sign of temporarily weak demand, which is something that policymakers there presumably wish to address, it still does not seem all that likely that they will find themselves in a deflation trap.

CONCLUSION

The first thing to say is that, for most countries, deflation is an outcome which is to be avoided, just like inflation is to be avoided. Stability in the general level of prices, interpreted in practice as a low but positive rate of price increase, is the appropriate goal. Forward-looking monetary policies should be seeking to maintain inflation above zero, just as actively as they look to keep it below some maximum rate. Also the thing to be avoided most strenuously is a persistent deflation which becomes embodied in expectations. It is in this situation where questions of deflation traps become relevant, particularly in countries where the natural interest rate has come down to very low levels. Policy must work at keeping price expectations from falling too far, just as hard as it worked to get expectations down from excessive levels in earlier times, by articulating goals clearly, and being seen to take action consistent with achieving those goals.

The fact that we are talking about the possibility of it at all is a remarkable change from only a few years ago. Insofar as that means that the 'great inflation' is well and truly finished, that is a good thing, provided of course that we are alert to the new sorts of risks, which can emerge. For the average country, a short-lived experience with mild deflation would just be a sign that there is a problem of insufficient aggregate demand which ideally should have been avoided, but which, failing that, should be addressed quickly. The observed deflation would be telling us the same thing as various real activity indicators: things are weak and the economy needs encouragement to grow.

The bigger concern would be the possibility of a 'deflation trap' where conventional monetary policy would become largely ineffective. It seems that in most countries this is not all that likely an outcome anyway, but good policies all round should be able to lessen the probability of it further.

REFERENCES

1. Amano, R, Coletti, D and Macklem, T (1998), 'Monetary rules when economic behaviour changes' 2. Athanasios Orphanides, 2001. "Monetary policy rules, macroeconomic stability and inflation: a view from the trenches," Finance and Economics Discussion Series 2001-62, Board of Governors of the Federal Reserve System (U.S.) 3. Stephen Icon, 2000. "Economics" pp. 202-216

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Federal Reserve System. (2018, Jul 30). Retrieved from https://phdessay.com/federal-reserve-system/

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