June 25, 2003
A "Deflationary Spiral"?!

Recent news articles on the economy have worried aloud of falling prices leading to a "deflationary spiral." The current economic malaise in Japan, as well as the Great Depression are sometimes cited as examples of such a spiral. But this fallacious description confuses basic economic concepts, and is similar to a trick question often given to introductory economics students.

The argument being made is that falling prices lead consumers to delay purchase (as they await lower prices) which further lowers demand and leads to lower prices, etc., and therefore leads to a deflationary spiral. It is important to understand that this description contains elements of truth which make it sound credible, but it is important to separate truth from sophistry.

What Is True
First, what is true in this description. It is true that economists believe there are feedbacks in the macroeconomy. The idea, for example, is that if I decide to lower my spending, this will lower the income of retailers who might then themselves spend less, lowering others' incomes, etc. etc. It is important to recognize that though such feedbacks occur, they are generally thought to be finite (and small) in nature: each round of indirect effects are thought to be smaller than the previous. The total (indirect + direct) effect of some spending shock is generally thought to be not much larger than the initial shock: estimates of the spending "multiplier" (as it is called), which measures the ratio of the total effect to the initial shock, are on the order of 1.1.

Second, it is also true that the lower the rate of inflation, (or the higher the rate of deflation) the more spending rational consumers will delay until the future, all else the same. This relationship between consumer spending and inflation can be thought of as partly responsible for generating the so-called Phillip's Curve, which describes the relationship between output and inflation (again, all else the same).

A Trick Question from Introductory Economics
Evil economists (such as myself) often try to fool their introductory economics classes with a problem of the following type. "Suppose demand for good x falls because of some shock (such as lower income). This causes the price of good x to fall. But this fall in price in turn raises demand for the good, so the net effect of the shock is ambiguous." What's wrong with this reasoning?

The first two sentances are fine, but it is not true that the fall in price raises demand for the good. And why not? Isn't that how demand is supposed to work? Not quite -- the problem is one of definition. Demand is a relationship rather than a quantity: it describes the relationship between price and quantity that is demanded by consumers. So while it's true that quantity demanded is higher a lower price, it is not true that demand is lower. Graphically, it's the difference between a shift of the whole demand curve (which is a shift in demand) and a movement along the curve (changes in quantity demanded). In the trick question above, the income shock shifts the demand curve inward, lowering the quantity of good x consumed in the intersection with supply (i.e. in equilibrium); the price is also falls in this new equilibrium.

Back to Macro
In a similar way, the Phillip's curve represents a relationship between two macroeconomic variables: output and inflation. They are thought to be negatively related, in part because of the reason described above -- at lower levels of inflation, consumers optimally choose to spend less today. But analagous to the problem above, we don't expect a one-time shift in this relationship -- due to a shock to consumer confidence, for example -- to cause inflation levels to continue to fall and fall and fall. Instead, we expect a new stable relationship between inflation and output to emerge.

And although the norm in our economy has been one of steadily rising prices, i.e. inflation, there is no reason to expect this price-output relationship to suddenly become steeper if inflation gets so low it actually becomes negative. The problem in Japan and in the US during the Great Depression was not of a "deflationary spiral" but of falling aggregate demand that decreased both prices and output.

In other words, low inflation or even falling prices are not the source of the problem -- they are a mere symptom of overall economic weakness. And it is that on which Fed Policy should be focused.

Posted by ethan at 07:18 PM