Thursday, March 09, 2006


Keynes Still Matters

This is in responce to Chris' earlier question concerning why deflation is bad.

Obviously, not all deflation (defined as a fall in general prices) is bad. A large increase in aggregate supply could lead to a booming economy and falling prices. But deflation originating from a sudden and dramatic collapse of aggregate demand could be worrisome because of the potential accompanying recession. "Well, wont this recession be self-correcting? If so, why worry?" you may ask. Maybe not. We can certainly conceptualize situations where the self-correcting mechanisms of the market fail. In this case, The real problem arises when deflation pushes nominal interest rates toward zero. Once nominal interest rates reach their zero bound, real interest rates will start rising with deflation, discouraging investment, worsening the recession and causing prices to fall further. If this continues, “deflationary expectations” could become entrenched in the minds of economic agents, catching the economy in a downward deflationary spiral known as a “liquidity trap”. There will be no self-correcting mechanism to pull the economy into recovery here.

Worse, with nominal interest rates already as low as they can go, central banks lose their ability to affect aggregate demand using traditional open market operations. This could be a situation very similar to the one Keynes described in the General Theory (an “equilibrium” bellow full employment where monetary policy is ineffectual), leaving the door open for the type of counter-cyclical fiscal policies he recommended.

Now, things aren't really this cut and dry and there is still debate over the practical importance of liquidity traps, but I think this is a good theoretical answer to Chris' question. If you are interested in learning more about the modern theory of liquidity traps see this speech by Ben Bernanke for an intuitive introduction or Paul Krugman’s explaination using the IS-LM model. If you would like a more rigorous treatment, check out Krugman’s paper on Japan’s recent deflationary experience.

"Once nominal interest rates reach their zero bound, real interest rates will start rising with deflation..."

Why would real interest rates rise?
The easiest way to think about it is using the Fisher equation: r = i - (inflation).

If nominal interest rates are at their zero bound they can't go any lower.

r = 0 - (inflation)

In the presense of deflation, this means we are subtracting a negative number (or more simply, always adding a positive number to the real interest rate). IOW: real interest rates cannot go any lower than the rate of deflation, and if deflation increases so will real interest rates.

Here is another little paper by Paul Krugman on modeling liqudity ttaps. I think it does a much better job than either of the first two articles of explaining why expectations are the crux of the story.
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Update: I re-wrote the post a little for stylistic reasons. I think it is a little clearer and has a little more "umph".
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