Sunday, January 18, 2015

Prices are Falling in the Eurozone, but is it "Real" Deflation?

The Eurozone has been on the brink of deflation for months. The latest data show that for the first time, consumer prices for the currency area as a whole (and for 12 of its 19 member countries) were actually lower in December than a year earlier. But is it “real” deflation?

In a pair of posts [1] [2] last fall, when EZ inflation was merely low, but not yet negative, I explained that there are two kinds of deflation.
The nasty kind of deflation, which everyone rightly fears, is driven by falling aggregate nominal demand. As demand collapses, it drags both real output and the price level down with it. There is a serious risk of a self-reinforcing downward spiral in which debtors can’t repay their loans, defaults and falling asset prices undermine the financial system, zero interest rates render monetary policy powerless, and rising unemployment sparks social unrest.

However, there is also a benign kind of deflation, driven by rising productivity. In that scenario, conservative monetary policy restrains the growth of nominal GDP while real output surges ahead. The rate of inflation is negative, but growing output provides borrowers with the cash flow they need to repay their loans, rising productivity allows real wages to rise, and nominal interest rates, although low, do not need to fall all the way to the zero bound. In the US and UK, such productivity-driven deflation was the norm during much of the nineteenth century and reappeared again, more briefly, in the prosperous 1920s.

So which kind of deflation is Europe facing now? The bad, demand-driven kind,  or the good, supply-driven variety? A little of each, it seems. >>>Read more

Follow this link to view or download a slideshow-tutorial, "Why Fear Deflation?".



  1. I started going through your slideshow, and I have to ask, what is the justification of subtracting the rate of inflation from the nominal interest rate? Every time I see this equation, I see no reason for it, because when I try to apply it to the real world, I don't see the connection. I still have to pay 5 percent, and I might get a raise once a year. All the while, in between the possibility of getting a raise to keep up with inflation, many other things go up in price...while I'm still paying the same for anything I borrowed at interest. So throughout the year, I'm getting poorer.

    I might as well subtract the number of HDTV's I have from the nominal interest rate...the math obviously works, but like subtracting the rate of inflation, it doesn't mean anything in the real world.

    Where are the proofs to show these equations as true? They remind me of what theoretical physicists do, pump out equations and whatnot that can't be proven, but they'll always have a job.

    1. Suppose you borrow $100 at the beginning of the year to purchase something at an interest rate of 5%, and the rate of inflation is 2% over the year; and you get no raise over the year. The cost to you of buying the item today is $105. (Its cost plus interest you paid). If you wait a year it will cost you $102 since prices increased by 2%. In effect the true interest you paid (i.e. real interest) was $3 or a rate of 3%.