Academic journal article Journal of Money, Credit & Banking

Moderate Inflation and the Deflation-Depression Link

Academic journal article Journal of Money, Credit & Banking

Moderate Inflation and the Deflation-Depression Link

Article excerpt

POLICYMAKERS SINCE THE Great Depression have been concerned that deflation can lead to lower growth rates, if not recessions, and the recent Japanese experience has exacerbated such concerns (see Krugman 1998). However, theoretical models offer differing perspectives. Milton Friedman's argument that for economic efficiency the nominal interest rate should be zero and that the price level should fall steadily at the real rate of interest is well known and has been formally reconfirmed by Chari, Christiano, and Kehoe (1996) and by Cole and Kocherlakota (1998) (see also Benhabib and Bull 1983). Others, working with calibrated models embedding sticky prices and market distortions, find the Friedman rule nonoptimal (Schmitt-Grohe and Uribe 2004). More to the point, Auerbach and Obstfeld (2005) find that the welfare and output costs associated with liquidity traps and deflations can be very significant.

Empirical evidence on the correlation between inflation and economic performance has cast doubt on the existence of a strong relationship. In a recent paper, Atkeson and Kehoe (2004) demonstrated the lack of a robust empirical relationship between inflation and growth for a cross-section of countries with nineteenth- and twentiethcentury data, concluding that the historical evidence only provides weak support for the contention that deflation episodes are harmful to economic growth. Bruno and Easterly (1998) also fail to find a relationship between inflation and growth over 30-year cross-country data, but they do find a negative relationship between high inflation--exceeding 40%--and growth over high-frequency data (see also Ghosh and Phillips 1998).

Folklore has it that too much inflation (hyperinflation) is bad for the economy because it increases "shoe-leather" costs and that deflation is also bad because prices are sticky, or because of other less-well-understood reasons that have something to do with expectations. If so, we should not expect a linear relation between growth and inflation, but an inverted U-shaped one. In this paper, we reexamine the long-term evidence on inflation and growth by considering such a nonlinear relationship.

Following the methodology of Atkeson and Kehoe (AK; 2004), we are only attempting to characterize the empirical relationship between inflation and economic growth, and do not claim that there are any causal conclusions from our results. Our analysis speaks to AK's conclusion based on a linear specification that the data show no obvious relationship, which raises the bar for those who claim that deflation and depression are closely linked. It may be the case that our nonlinear specification might proxy for other missing variables that might be included in a more structural specification.

Using a long cross-country panel data set of 5-year growth episodes, we examine a nonlinear specification that allows for the capture of an inverted U-shape. We obtain a large and statistically significant estimate of the relationship between inflation and growth in ranges of moderate to negative inflation.

We then divide the sample according to inflation levels, using both the Hansen (2000) method and an imposed break at the sample 50th percentile. These correspond in our full sample to annual inflation rates of 3.23% and 2.44%, respectively. (1) We examine a simple linear specification for the subsamples with average 5-year inflation levels below and above these threshold levels. Our results again show that for subsamples limited to negative and moderate inflation levels, the relationship between inflation and growth is positive and quite strong.


Our data set is very similar to that in AK. (2) Our sample begins in 1859, as data for earlier 5-year episodes are often unavailable for more than two countries, and ends in 2004. Data on the general price level and output data up to 1980 are obtained from Rolnick and Weber (1997) and Backus and Kehoe (1992) for Argentina, Australia, Brazil, Canada, Chile, Denmark, France, Germany, Italy, Japan, Netherlands, Norway, Portugal, Spain, Sweden, United Kingdom, and United States. …

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