Economic Problems of Deflation
November 21, 2001
A number of economists have warned for years that deflation was the economy's most serious problem. Deflation is negative price inflation, or a simultaneous fall in a broad range of prices for many goods and services.
A sustained deflation has serious economic effects:
- For instance, it raises the real interest rate -- the market rate minus the change in prices. (Thus if prices fall 5 percent per year and the nominal interest rate is a modest 3 percent, the real interest rate is actually a high 8 percent.)
- Sustained deflations also raise real wages -- leading to layoffs as employers try to economize on labor costs.
- And deflation rewards creditors and those with cash at the expense of debtors and those with illiquid assets.
- Most economists believe sustained deflation is far more damaging than an equivalent inflation -- indeed, a recent Milken Institute study argues economic growth is maximized at an inflation rate between 1.6 percent and 3 percent per year.
A sustained fall in sensitive commodity prices -- those that lead changes in the general price level, such as gold, the exchange value of the dollar and prices of long-term Treasury securities -- will eventually affect the whole economy.
Now we are starting to see deflation showing up in price indexes.
- The Consumer Price Index fell 0.3 percent in October and the Producer Price Index dropped a huge 1.6 percent.
- Because sensitive prices have yet to turn up, economists such as Jude Wanniski of Polyconomics.com say recent declines in the CPI and PPI will continue due to past Federal Reserve tight monetary policy.
However, some economists maintain inflation is the true economic problem. Milton Friedman has warned that previous increases in the money supply may lead to inflation next year.
Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, November 21, 2001.
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