Deflation

1
Deflation

• Notes for Macrorisks course Università di Milano
  Bicocca
• Based on Krugman 2008 and IMF 2009

2
Introduction
3
Deflation a theoretical perspective

• Excess capacity?

4
Deflation a theoretical perspective

• It should be easy to move AD up and right?
  Shouldnt it? But this is not always the case,
  especially if rates are already at zero
  (liquidity trap)!

5
Deflation a theoretical perspective

• (1i)(P/Pe), Clearly, the economy "wants" a
  lower value of P/Pe, in the same sense that Hong
  Kong's economy "wants" a depreciated real
  exchange rate. And because Pe is sticky - because
  people have some notion about what prices will be
  in the future  - this adjustment is coming via a
  fall in P

6
Policy implications

• One answer is to pursue structural reforms that
  eliminate the savings-investment gap
• A second answer is to close the
  savings-investment gap with government dissaving.
  The trouble with this solution, of course, is
  that it poses problems for the long-term solvency
  of the government
• The obvious third answer to sustained
  deflationary pressures, then, is the
  now-notorious proposal for "managed inflation"
  since deflation is the result of an economy
  "trying" to get the expected inflation it needs,
  to avoid deflation one must provide that expected
  inflation by credibly promising that future price
  levels will be sufficiently high compared with
  the present (crazy idea, what about reputation?)