Question

Explain how an economy can experience long-run economic growth and deflation at the same time?

Answer 1

The Federal Reserve-led group of central bankers has encouraged a near-obsessive fear of inflation that is too low / deflationary. There are two possible causes of deflation: monetary deflation and technological deflation that would result from higher productivity growth (in my opinion obviously positive, as higher productivity growth encourages higher long-term wealth and real income). Apart from the Great Depression and Japan's (plus) missing decade, there is no evidence that deflation is hurting economic growth. Those two incidents, however, were major financial disasters with bank failures and it is difficult to discern if the damage was caused by deflation per se or bank failures.

The ideal inflation rate was negative in terms of the real interest rate, because there would be no incentive to save money balances (because short-term financial instruments would also yield zero nominal). The issue with the fear of deflation is that monetary policy is held too loose at low inflation levels to avoid a risk of deflation and this manipulation of nominal rates may trigger more harm than good

The central bankers believe they can manage inflation. The 1930's German hyperinflation has been so far back in the past, and has happened in such a different world economic climate that it is not considered significant. Today, however, it is easier for central bankers to refer to the success of Paul Volcker's intervention in the 1970's that China's rise followed by other developing countries 'increased productivity (as generally calculated by economists) and was a worldwide deflationary factor by implementing a large, lower-paid and increasingly skilled labor force. Notwithstanding this, central banks seem to believe they have the formula to manage high inflation.

On the other hand, they are fearful of deflation, as they do not seem to have the means to counter it. The depression of the 1930s is an example, but also the Japan lost decade that you list correctly is in their minds closer and more vividly present.