Question

 

1. Consider the experience of Japan in the past two decades and of Europe more recently. What are the causes of deáation in those countries?

2. How do central bankers typically feel about deflation? Why?

3. Consider our basic OLG model when the population is growing and the supply of money is fixed.

(a) Summarize the key predictions of this simple model.

(b) Are there any predictions of the model which seem particularly at odd with the conventional wisdom of central bankers about deflation? If yes, provide

an interpretation of the possible sources of this disagreement.

(c) To what extent does this simple model help you understand deflation in Japan?

Article:

Europe: Deflation decoded

The spectre of deflation descended over the global economy this week as the eurozone recorded falling prices for the first time in more than five years, raising fears that the world could enter a vicious circle of sliding incomes and spending.

Prices in the eurozone dropped by 0.2 per cent in the year to December, following a 50 per cent drop in oil prices since June. While many economists had seen this coming in the currency union, there are now fears that deflation could spread. With oil prices at $50 a barrel, at least 18 states — including Germany and the UK — could see negative inflation, according to estimates by Oxford Economics.

Deflation fears rattled the stock market, with global shares plunging on Monday before paring back their losses. Investors know that once an economy falls into outright deflation — a persistent and generalized fall in prices — it is very difficult to climb out. This is what happened in Japan, where policy makers have struggled to lift prices since 1999. But while Japan offers a cautionary tale, it does not have to be that way.

Japan is an example of “bad” deflation, where prices fall as a result of slowing demand. As consumers expect goods to become cheaper in the future, they postpone purchases, worsening the slump. If price levels keep sliding, nominal incomes may start to fall, making it much harder to service debt. A wave of bankruptcies can follow, compounding the misery.

But there is also a rosier deflation scenario. Falling prices can be the result of better productivity, as workers create goods and services at a lower cost. Sliding import costs can also have a positive effect, boosting disposable income.

This happened in West Germany in 1986, when consumer prices dropped by up to 1 per cent as oil prices fell, but output over the next three years grew by a healthy average of 2.9 per cent.

The question for investors and politicians is which of these two scenarios the world economy is in. For now, the drop in prices appears to resemble the experience of the late 1980s more than the Depression years of the 1930s. Inflation has been largely driven down by the cost of energy, while core inflation —which strips the effect of goods with more volatile prices — has generally held up.

Nor is there much evidence that consumers are delaying purchases in the expectation that prices will keep falling. Retail sales growth across advanced economies rose by about 2 per cent in the year to November, according to estimates by Capital Economics.

In fact, so long as the price decline remains limited to energy, there is little reason to believe this change in psychology will happen. “Why should a consumer look at a lower oil price and say ‘the cost of filling the family SUV with gasoline has gone down, I had better not buy that flat screen TV that I want, because it will be cheaper next month?’,” said Paul Donovan, a UBS economist.

And despite falling inflation, experts at the World Bank and the International Monetary Fund still expect global growth to be faster in the coming year thanks to lower oil prices.

There is a big exception to the rosy scenario, however: the eurozone and, in particular, its more troubled“periphery” countries such as Greece and Spain. A survey of inflation expectations carried out inDecember for the European Commission shows buyers expected prices to be flat over the next year.

These worries will be weighing on the European Central Bank when it meets on January 22. Many analysts say the ECB will have no choice but to embark on a sovereign bond-buying programme in the hope of boosting inflation.

“The pressure remains firmly on the ECB to deliver a sizeable quantitative easing programme at its meeting later this month to prevent deflation from becoming firmly entrenched,” said Jessica Hinds of Capital Economics.

Central bankers in the US, the UK and elsewhere have fewer reasons to worry for now. But they will be watching prices like hawks.

A short bout of deflation can be a blessing for consumers, especially when it is driven by a slide in the price of oil or another imported necessity. Households find that their paycheques go further. And lower prices also mean that indebted households have more money to payoff what they owe.

But a protracted period of deflation will have a different effect on shoppers’ behaviour. Knowing that all goods will be cheaper tomorrow than today, they will postpone their purchases. This has a pernicious effect on businesses, which face a slump in demand and a squeeze in profits.

The financial troubles of companies are bound to have an impact on households. Some will face the prospect of lay-offs or pay cuts, reducing their disposable income and hurting consumption. Even those who are spared will face greater uncertainty and may save more of their income, further weighing on demand. Finally, indebted workers will find it harder to pay back their debt, which is rising in real terms as wages remain stagnant or fall.

Aprotracted period of low prices makes it more likely that workers will not ask for higher wages when they bargain with employers. In fact, they may be perfectly content to accept a stagnant salary, as this would still increase their purchasing power in the face of sliding prices. This effect on wage negotiation is one of the reasons it is so hard to leave a prolonged period of deflation.

Shinzo Abe, Japan’s prime minister, has urged companies to pay more to their workers, as he sees bargaining rounds as a key battleground in his fight against deflation. But so far, wage growth is still sluggish.

Companies: Winners and losers

The impact of deflation on businesses depends on how the price of their products moves relative to the cost of inputs needed to make them.

The recent plunge in crude prices helps to explain how this works.

Businesses whose costs are heavily dependent on the price of oil, such as airlines, have enjoyed a bumper few months.In December, analysts at Barclays estimated that the US aviation industry could see their costs drop by $10bn. This will translate into fatter profit margins.

Conversely, oil majors are suffering from a significant squeeze in their profits, as the value of their output falls, while their input prices are roughly unchanged.

Not all corporations are equally vulnerable: relative financial strength depends on factors such as debt levels or the strength of cash flow. Investment prospects, however, can be hit severely, though this depends on future oil prices rather than on current ones.

In a scenario of generalised deflation, however, all companies face a tricky balancing act.With output prices falling, managers will have to take the axe to their costs to preserve profit margins.This means cutting workers’ pay, for example.

However, economists generally think of wages as “sticky downwards”: meaning it can be hard to impose nominal cuts to the value of a worker’s pay. This means they have to cut jobs, worsening the slump by raising unemployment.

Full-blown deflation will also put the stability of the financial sector at risk. In theory, falling prices help creditors, who see the real value of their loans rise.

But, a prolonged period of stagnation could lead to a wave of bankruptcies, which will hit the banks’ balance sheets. Lenders will also suffer from any fall in asset prices, which will reduce the value of any collateral they hold.

Markets: Watch the ripple effects

Deflation has profound consequences for financial markets.The initial effects are clear-cut, but the secondary responses are far harder to predict. In a deflationary environment, the biggest winners are conventional fixed-income bonds. They pay a coupon whose value will rise over time if deflation persists. The biggest losers are index-linked bonds. Beyond the bond market, cash grows more popular, even when it pays virtually zero interest, because it will grow in value with deflation. Financial engineers would likely redouble their efforts to find ways to guarantee returns. Commodity prices fall, by definition. As for equities, deflation implies a lack of corporate pricing power and a lack of growth — both bad for stock markets. But David Bowers of London’s Absolute Strategy Research points out that money will flow to companies that can make themselves as bond-like as possible. They can do this by paying out more cash in dividends, or by buying back their own stock. As he puts it, “companies are incentivised torun themselves for cash”. This leads to the potential second-order effects. If companies have an incentive to pay out cash, they tend to spend less on capital investments — which weakens economic growth. Companies appear to have already started adapting. For the 12 months to the end of September,Howard Silverblatt of Standard & Poor’s found that S&P 500 companies spent $902bn on buybacks and dividends combined — an increase of 20 per cent compared with a year earlier. This far outstrips the growth in their earnings or revenues . And it was also 5.5 times the $164.7bn they devoted to capital expenditures. The late 1990s equity market led to wild over-investment by companies, particularly in the US. The fear now is that deflation would prompt markets into forcing under-investment, as companies tried to make their stocks look like bonds. John Authers Central banks: Eye on the target Over the past two decades, many central banks around the world have adopted inflation targets, meaning their decision to cut or raise interest rates depends on how indices of prices are moving. Their key measure is typically“headline” inflation, which includes all goods and services. As a result, sharp drops in the cost of volatile products, such as oil, can lead to steep deviations from a central bank’s target. Policy makers try to ignore such swings and concentrate on “core inflation”, a measure that excludes volatile energy and food prices. And since central bankers are normally interested in maintaining price stability over the medium term, this allows them to avoid knee-jerk reactions to temporary swings.

The risk for the monetary authorities, however, is that even a temporary bout of deflation can alter consumers’ expectations, changing their spending behaviour and the wages they demand from their employers. At that stage, it becomes very hard for the central bank to lift inflation back to its target: the Bank of Japan has kept interest rates near zero for the past 15 years, but this has largely failed to prompt a sustained rise in the price level.

In an environment of persistent deflation, monetary policy makers face an uphill battle. Central bankers stimulate the economy by reducing the so-called real interest rate, a way of encouraging households and companies to invest instead of save. When prices are falling, nominal interest rates must be pushed to extremely low levels to boost output.

But sometimes even this is not enough. When demand is extremely weak, central bankers need to slash nominal interest rates below zero to give enough of a boost to demand. But this is impossible, as savers would take their money out of the bank. Central bankers then have to implement unorthodox measures, which could include quantitative easing.

Answer 1

Definitions:
Defaltion: It can be defined as decrease in overall price level so that inflation rate becomes negative.

Nominal interest rate: It is the interest rate before taking inflation into account.

Real interest rate: It is the interest rate calculated after taking inflation into account
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Ans 1) Causes of deflation in Japan and Europe:

Europe: Deflation hit Europe due to fall in oil prices since June, this in turn led to fall in prices in the eurozone by 0.2%. However, despite falling inflation, experts at the World Bank and the International Monetary Fund still expect global growth to be faster in the coming year thanks to lower oil prices. And fall in oil prises does not affect the medium term core inflation target of the central banks.

Japan: The reason for deflation in Japan has been the fall in prices due to fall in demand. And this situation has been since 1999. And the reason for the fall in demand, is that the consumers postponed their purchases as they expected the prices to reduce further in the near future. This in turn reduces demand and as a result fall in prices, as a result the manufacturers are forced to reduce their output to reduce loses and layoff employees, this gives rise to unemployment and as a result further fall in demand for goods. Thus it gives rise to a vicious cycle.

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Ans 2) The drop in prices current drop in prices (deflation) appears to resemble the experience of the late 1980s more than the Depression years of the 1930s. Inflation has been largely driven down by the cost of energy, while core inflation has generally held up.
And despite falling inflation, experts at the World Bank and the International Monetary Fund still expect global growth to be faster in the coming year due to lower oil prices.
Many central banks around the world have adopted inflation targets, meaning their decision to cut or raise interest rates depends on how indices of prices are moving. Their key measure is typically “headline” inflation, which includes all goods and services. As a result, sharp drops in the cost of volatile products, such as oil, can lead to steep deviations from a central bank’s target. And since central bankers are normally interested in maintaining price stability over the medium term, this allows them to avoid knee-jerk reactions to temporary swings.
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Ans 3) a) Overlapping Generations Model (OLG) with an aggregate neoclassical production was given by Peter Diamond. The economy has following characteristics:
- Two generations are alive at any point in time, the young and old.
- Households work only in the first period of their life and earn Y1,t income.

- They earn no income in the second period of their life (Y2,t+1 = 0)
- They consume part of their first period income and save the rest to finance their consumption when old.
- individuals tend to save more than is socially optimal, leading to dynamic inefficiency.

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b)The OLG model predicts that individuals consume part of their first period income and save the rest to finance their consumption when old. Saving for future consumption leads to reduced demand in the present period, and this is at odd with the conventional wisdom of central bankers about deflation. Central bankers stimulate the economy by reducing the so-called real interest rate, a way of encouraging households and companies to invest instead of save. As increase in ivestment will increase output and increase in demand for goods in the economy and which in turn will help the economy to come out of deflation.

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c) deflation in Japan:

Japan is an example of “bad” deflation, where prices fall as a result of slowing demand. As consumers expect goods to become cheaper in the future, they postpone purchases, worsening the slump.

Also Japan is facing a demographic stage where it has larger proportion of aging or old people as compared to young working class. As a result earning population is less than old people living on saved income or pensions. Hence there is continous fall in demand for goods and services which in turn is causing deflation. And this situation also has led to decrease in investment which is bad for the economy. At that stage, it becomes very hard for the central bank to lift inflation back to its target: the Bank of Japan has kept interest rates near zero ( to disincentivise saving and invest more) for the past 15 years, but this has largely failed to prompt a sustained rise in the price level.