Answer the following discussion questions for each of the articles appearing at the end of this document. For each question write no more than 15-20 lines. Use models, graphs and concepts developed in class to illustrate your answers when helpful. This exercice is intended to test your capacity to use learnt material to analyse real economic issues discussed in articles. ARTICLE 3 Deflation and the Zero Bound on Interest Rates Deflation: Making Sure "It" Doesn't Happen Here Governor Ben S. Bernanke National Economists Club, Washington, D.C. Since World War II, inflation--the apparently inexorable rise in the prices of goods and services-has been the bane of central bankers. Economists of various stripes have argued that inflation is the inevitable result of (pick your favorite) the abandonment of metallic monetary standards, a lack of fiscal discipline, shocks to the price of oil and other commodities, struggles over the distribution of income, excessive money creation, self-confirming inflation expectations, an "inflation bias" in the policies of central banks, and still others. Despite widespread "inflation pessimism," however, during the 1980 s and 1990 s most industrial-country central banks were able to cage, if not entirely tame, the inflation dragon. Although a number of factors converged to make this happy outcome possible, an essential element was the heightened understanding by central bankers and, equally as important, by political leaders and the public at large of the very high costs of allowing the economy to stray too far from price stability. With inflation rates now quite low in the United States, however, some have expressed concern that we may soon face a new problem-the danger of deflation, or falling prices. That this concern is not purely hypothetical is brought home to us whenever we read newspaper reports about Japan, where what seems to be a relatively moderate deflation--a decline in consumer prices of about 1 percent per year-has been associated with years of painfully slow growth, rising joblessness, and apparently intractable financial problems in the banking and corporate sectors. While it is difficult to sort out cause from effect, the consensus view is that deflation has been an important negative factor in the Japanese slump.... Deflation: Its Causes and Effects Deflation is defined as a general decline in prices, with emphasis on the word "general." At any given time, especially in a low-inflation economy like that of our recent experience, prices of some goods and services will be falling. Price declines in a specific sector may occur because productivity is rising and costs are falling more quickly in that sector than elsewhere or because the demand for the output of that sector is weak relative to the demand for other goods and services. Sector-specific price declines, uncomfortable as they may be for producers in that sector, are generally not a problem for the economy as a whole and do not constitute deflation. Deflation per se occurs only when price declines are so widespread that broad-based indexes of prices, such as the consumer price index, register ongoing declines. The sources of deflation are not a mystery. Deflation is in almost all cases a side effect of a collapse of aggregate demand-a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers. ... Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending-namely, recession, rising unemployment, and financial stress. However, a deflationary recession may differ in one respect from "normal" recessions in which the inflation rate is at least modestly positive: Deflation of sufficient magnitude may result in the nominal interest rate declining to zero or very close to zero. 1 Once the nominal interest rate is at zero, no further downward adjustment in the rate can occur, since lenders generally will not accept a negative nominal interest rate when it is possible instead to hold cash. At this point, the Deflation great enough to bring the nominal interest rate close to zero poses special problems for the economy and for policy. First, when the nominal interest rate has been reduced to zero, the real interest rate paid by borrowers equals the expected rate of deflation, however large that may be. 2 To take what might seem like an extreme example (though in fact it occurred in the United States in the early 1930 s), suppose that deflation is proceeding at a clip of 10 percent per year. Then someone who borrows for a year at a nominal interest rate of zero actually faces a 10 percent real cost of funds, as the loan must be repaid in dollars whose purchasing power is 10 percent greater than that of the dollars borrowed originally. In a period of sufficiently severe deflation, the real cost of borrowing becomes prohibitive. Capital investment, purchases of new homes, and other types of spending decline accordingly, worsening the economic downturn. ... Under normal conditions, the Fed and most other central banks implement policy by setting a target for a short-term interest rate-the overnight federal funds rate in the United States--and enforcing that target by buying and selling securities in open capital markets. When the shortterm interest rate hits zero, the central bank can no longer ease policy by lowering its usual interest-rate target. Because central banks conventionally conduct monetary policy by manipulating the short-term nominal interest rate, some observers have concluded that when that key rate stands at or near zero, the central bank has "run out of ammunition"-that is, it no longer has the power to expand aggregate demand and hence economic activity. It is true that once the policy rate has been driven down to zero, a central bank can no longer use its traditional means of stimulating aggregate demand and thus will be operating in less familiar territory. The central bank's inability to use its traditional methods may complicate the policymaking process and introduce uncertainty in the size and timing of the economy's response to policy actions. Hence I agree that the situation is one to be avoided if possible. ... Footnotes 1. The nominal interest rate is the sum of the real interest rate and expected inflation. If expected inflation moves with actual inflation, and the real interest rate is not too variable, then the nominal interest rate declines when inflation declines-an effect known as the Fisher effect, after the early twentieth-century economist Irving Fisher. If the rate of deflation is equal to or greater than the real interest rate, the Fisher effect predicts that the nominal interest rate will equal zero. Return to text 2. The real interest rate equals the nominal interest rate minus the expected rate of inflation (see the previous footnote). The real interest rate measures the real (that is, inflation-adjusted) cost of borrowing or lending. 3. Suppose that an economy is suffering from a rapid rate of deflation, perhaps at 20% per year. By cutting interest rates to zero, the central bank can only reduce the real interest rate to 20%, still a very high level. Can you think of some extreme action that the central bank could undertake that would drastically increase the purchases that consumers want to make and would therefore start to make prices increase? (Hint: Remember that the central bank can print as much currency as it wants.)