Deflation is not worse than inflation

Just over nine years ago, Ben Bernanke gave a famous speech entitled “Deflation: Making Sure ‘It’ Doesn’t Happen Here.” He articulated a view that has since become completely mainstream, namely, that falling prices are far worse than rising prices. Why should this be?

Orthodox macro economists fear deflation (negative changes in the consumer price index) more than inflation (positive changes in the consumer price index) for three reasons. Professor Krugman provided a good summary of the standard argument.

First, falling prices supposedly create expectations of further price declines. This supposedly encourages households and businesses to postpone spending and hoard cash, which could induce a recession. Second, falling prices often—although not always—go hand-in-hand with declines in nominal wages, which means that deflation increases the burden of existing debts. Finally, it is supposedly harder to stop prices from falling than to stop them from rising because the central bank could push nominal interest rates up towards infinity but cannot push them below 0%—hence the so-called “zero bound.”

It turns out, however, that all three of these arguments are either flawed or incomplete. Broad declines in nominal wages and prices, while generally undesirable, are no worse than broad increases in nominal wages and prices.

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The lessons of the baby-sitting co-op reconsidered

During the depths of the Asian Financial Crisis, Professor Paul Krugman wrote an essay for Slate where he argued that central banks can prevent recessions by manipulating interest rates. To make his point, the professor used a real-life example of a baby-sitting cooperative from the 1970s. It is well worth reading, particularly the second footnote at the bottom.

The original article on which Krugman’s piece was based is even more interesting. The authors came to a very different conclusion from the professor, however, which has significant implications for today’s debates on monetary policy and the economy.

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