Saturday, 1 June 2013

Inflation and deflation traps, just deflation traps, or neither?

In this short article for The Economist, the author discusses the so-called deflation trap. In particular, the author states that, "runaway deflation [...] can be much more damaging than runaway inflation, because it creates a vicious spiral that is hard to escape." The author goes on to explain that, under deflation, since consumers expect prices to be lower in the future, they tend to postpone consumption. As a result, producers tend to cut prices, which increases expectations of deflation on the parts of consumers, causing them to postpone consumption further. In other words (if I understand the argument correctly), expectations of deflation may give rise to a self-reinforcing process whereby prices continually fall. The author also points to a couple of other potentially damaging consequences of deflation, which I will come back to at the end.

My question is: why doesn't similar reasoning apply to the case of inflation? In particular, why isn't the following argument also sound? Under inflation, since producers expect prices to be higher in the future, they should tend to postpone selling. As a result, consumers should tend to offer more money, which should increase expectations of inflation on the parts of producers, causing them to postpone selling further.

An objection I've heard to this argument is that, in fact, a (non-catastrophic) equilibrium will be reached because consumers will raise the amount they offer to producers to such an extent that producers will be made indifferent between selling goods now and selling them later. And this makes intuitive sense to me. But if it is a valid objection, why doesn't it also apply to the case of deflation? I.e., under deflation, why don't sellers lower their prices to such an extent that consumers are made indifferent between purchasing goods now and purchasing them later? I am genuinely interested to know the answer to this question, or––indeed––whether I have misunderstood the author's original argument.

As I mentioned at the beginning, the author points to two additional consequences of deflation: first, it increases the real burden of debt; and second, it may render monetary policy ineffective. Unless I am mistaken (which I very well could be), the first of these two consequences should not result in a large and rapid fall in prices, and the second should only do so via the process outlined above. In conclusion then, if deflation traps are theoretically possible, why aren't inflation traps also theoretically possible? I should emphasise that my aim here is not to so much to defend a conclusion as to pose a question for those who know more about macro-economics than I do.

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