Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Classical Deflation Theory

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Classical Deflation Theory

Article excerpt

Deflation, the opposite of inflation, is a situation of falling general prices. It should not be confused with disinflation, which refers to a declining inflation rate that nevertheless remains positive. It was the successful U.S. disinflation of the 1990s, a disinflation that lowered the inflation rate sufficiently to create concern that further downward pressure might push it into negative territory, that spurred recent fears of deflation. These fears have materialized in Japan, where deflation coincides with cyclical recession and stagnant growth. Most famously, deflationary fears became reality in the 1929-1933 Great Contraction in the United States when prices fell by a fourth while output was falling by two-fifths.

Such episodes indicate that dread of deflation stems from its association with unemployment, business failures, and financial stress. Deflation tends to occur in cyclical slumps when collapses in aggregate spending force producers to cut prices continuously in a desperate effort to attract buyers. While these cuts eventually help to revive economic activity, they hardly work instantaneously. In the meantime, output and employment languish. The best alternative, therefore, may be to avoid deflation altogether by deploying monetary and fiscal policies sufficient to maintain economic activity at full capacity levels with low and stable inflation.

Absent in much of the recent worry over falling prices is the recognition that deflation is hardly a new topic or a new event. Classical (circa 17501870) monetary theorists, in particular, had much to say about it. Classicals, of course, abhorred deflation because, when unanticipated, it occasioned arbitrary and unjust redistributions of income and wealth from debtors to creditors. But classicals looked beyond these distributional outcomes involving equal but opposite transfers from losers to gainers to deflation's adverse effects on output and employment. As we will see, classicals attributed such adverse effects to price-wage stickiness; to rising real debt, tax, and cost burdens owing to lags in the adjustment of nominal values of those variables to falling prices; to the hoarding (rather than spending) of cash in anticipation of future deflationary rises in the purchasing power of money; and to other determinants. In general, classicals assumed that deflation was unanticipated, the exception being their analysis of hoarding where they took expectations into account.

Generally, classicals wrote during or following periods of wartime inflation under inconvertible paper currencies. At such times the government had committed itself to return to gold convertibility at the pre-war parity. Such restoration, of course, meant that the price of gold, goods, and foreign exchange-all of which had risen roughly in the same proportion during the war1-had to fall to their pre-inflation levels. Achieving these price falls, however, required contractions of the money stock and so the level of aggregate nominal spending. Owing to the above-mentioned temporary rigidities in either final product prices or nominal costs of production, these falls in spending would depress output and employment first before they lowered costs and/or prices. With prices sticky, falling expenditure would show up in reductions in the quantity of goods sold. Unsold goods, the difference between production and sales, would pile up in inventories, thus inducing producers to cut back output and lay off workers. And if rigidities lodged in costs instead of prices, a reduction in spending would drive product prices below (inflexible) costs. The resulting losses (negative profits) would force producers to contract their operations. Eventually, however, rigidities would vanish, and prices and costs would fall in proportion to the monetary contraction. When this happened, real activity would return to its natural equilibrium or full-employment level, but not before workers and producers had suffered painful losses of income and employment. …

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