June 02, 2003

Notes: Teaching: Deflation

Note: Add this to the reading list for my fall 2003 Economics 101b Intermediate Macroeconomics course?

Monetary Policy in a Zero-Interest-Rate Economy , May 2003, FRB Dallas, by Evan Koenig and Jim Dolmas

Posted by DeLong at June 2, 2003 10:09 AM | TrackBack


All the concerns about deflation seem to rely on the importance of real as opposed to nominal interest rates.

Clearly the distinction is important in many cases -- no-one in Turkey believes they are rich because the bank account pays 75% (well ok some probably do). But is it so true at low interest rates? Certainly in Britain each time interest rates fall house prices surge upwards, even though real interest rates are about the same as they have been for years.

In other words, everyone seems to assume that 3% real interest rates (0% nom and 3% deflation) will lead to an economic slump, but I think it might -- in the UK at least -- lead to an economic boom, at least initially.

Posted by: Matthew on June 2, 2003 10:50 AM

The Fed paper notes that "at a zero interest rate, a Treasury bill is no different from vault cash or large-denomination currency"

If I understand correctly, the argument is that with a zero rate, banks will not lend out the new reserves. But can't the newly created cash be used to purchase other assets?

Posted by: JT on June 2, 2003 02:55 PM

why not lower reserve requirements on bank deposits or margin ratios for equities/future/options?

Also, a question on this topic if anyone is still reading.

Does borrowing on margin to buy equities, options or futures (or shorting a financial instrument) act in the same way to create money supply (M2) as the reserve multiplier for banks?

Basically, if I buy a stock on 50% margin (assuming the seller didn't use margin also) haven't i just increased the money supply by half of the amount I bought the stock for? Or does the brokerage firm, from which I am borrowing the funds, nuetralize this by some mechanism I am not familiar? Do brokerage firms have to borrow funds on a 1:1 basis for all funds borrowed by their clients or do brokerage firms in effect have the ability to have less than 100% in reserve like banks do?

Posted by: alex on June 2, 2003 04:34 PM

"Certainly in Britain each time interest rates fall house prices surge upwards, even though real interest rates are about the same as they have been for years.

In other words, everyone seems to assume that 3% real interest rates (0% nom and 3% deflation) will lead to an economic slump, but I think it might -- in the UK at least -- lead to an economic boom, at least initially."

Yes, I believe that the low nominal interest rates (even at high real interest rates) result in a short-term stimulus, especially in regards to housing, because the expectation is that inflation in the future will be higher, so it is best to lock in interest rates at the low nominal rate.

Locking in interest rates at 3 percent interest rates today with 0 percent inflation might have a higher real interest rate, but, in the future, when inflation will probably rise to say 4 percent, the real interest rates could actually be negative...or at least this is what I'm guessing since I'm no economist. :(

I thought I read in the economist's housing survey, though, that Brits could not lock-in their interest rates...maybe i misread it.

In any case, I'm curious on the impact of all this on the solvency of banks. Loaning out all this money to indebted Americans at low interest rates with the possibility of deflation (and lots of defaults!) seems rather reckless.

Posted by: Sean on June 2, 2003 08:48 PM


A 10% fixed loan at 5% inflation is not the same as a 5% fixed loan at 0% inflation. In the first case, your loan payments stay constant even as your income increases, so if you can afford it the first few years the loan payments begin to fall in real terms. If you borrow at 0% inflation, 10 years from now the payments are still significant. The higher inflation is, the faster you pay off principal in real terms. (if inflation were 100%, you would pay an extra 200K interest on a 200K loan, and your house might now be worth 400K.... so after only 1 year your equity in the house is > 50%).

If you wanted to alter the loan contract to fix this you can have payments of real interest + some % of principal (the % depends on the year)and then add inflation back to the principal, which should be ok because it corresponds somewhat to the value of the asset which backs it.

Also, current inflation is not the same as future inflation, and a long term loan is a bet on nominal rates, which is what Sean is saying.

Posted by: snsterling on June 2, 2003 10:17 PM

There's quite a good article in the FT today about how deflation might not be so bad.

Posted by: Matthew on June 3, 2003 07:25 AM


1) it happened in the 19th century

Life was very different then. I would be curious to know how much spending was optional to a middle class family. By optional I basically mean not resulting in starvation or death or quality of life far out of line with what was expected. A modern economy depends on hummers, playstations, plastic surgery, exotic pets, pet psychotherapy, spacious houses with nice landscaping, big screen TV, etc. Also, it is not deflation that is a problem, the problem is what if we need interest rates below zero.

2) We buy computers even though their price goes down

Every purchase can be viewed as a rental, so all this means is that the purchase has a benefit per time greater than the depreciation on it. But this is not the point. Computers are only a part of the economy, so it does not matter if I am reducing some particular purchase due to deflation in that sector--interest rates already take into consideration our computer purchasing behavior and we produce other things instead. If the economy as a whole was subject to reduced purchases then job losses occur.

3) We will buy services anyway

It is not enough that we continue to purchase goods and services. At 2-3% productivity growth (if it continues) it is necessary that we increase consumption in order to prevent job losses. In a modern economy there is so much "fluff" that if a typical consumer wanted to or had to cut back 30% for whatever reason (need to save for future, job loss or insecurity, major terrorist event) they could still live reasonably well. I guess it depends how you define that, but it equates numerically to about 1980 standard of living.

4) we could impose negative interest rates

Not really. Not without major changes which eliminate paper money. It doesn't cost so much to store cash in vaults if it is done on a large scale basis. Certainly a lot less than several % a year. Also, the penalty on cash tax payments makes no sense, because the bad money (deflatable) will drive out the good money (non-deflatable). Simply pay tax with your current income and continue to hold paper savings. And even if you did go to a bank to deposit cash and there is a penalty on this, how do they know how long I've had the cash for?

5) The writer is professor of economics at the Central European University, Budapest and a trustee of the CASE Foundation, Warsaw

I am not a professor or trustee of anything, yet I'm quite sure I make more sense than the writer. Note that current holders of bonds have an incentive to prefer ever lower inflation, especially if their jobs are secure.

Posted by: snsterling on June 3, 2003 09:56 AM

What a load of entirely unperceptive comments. Why did you bother? What does your last sentence mean? Have you ever tried to write in English?

Posted by: George on June 3, 2003 02:23 PM

Thank you George. As a result of your well stated rebuttal I wish to revise point 4.

I didn't realize at first that the author of the article is intending to establish e-cash as the national currency and keep a running conversion rate between cash and e-cash. This is something I have stated that I would support if it ever came to be needed, but I'm not sure how acceptable it would be politically. The idea is correct, but there are many who will attempt to think in terms of the paper currency and might not like the idea that the paper money doesn't hold some absolute value. They might consider it to be a form of tax although it is not. I am also not sure if it will get too confusing to use the paper currency while using the e-cash.

The author makes it sound like such a small difference, but I think this is a pretty large step which would be avoided unless things manage to get really really bad. Possibly the author would advocate the use of this measure in Japan, but this good idea will not be applicable to an economy in which it is not implemented.

Posted by: snsterling on June 3, 2003 09:16 PM
Post a comment