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Related to deflations: Deflationary spiral, Negative Inflation
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The Great Depression produced more alarming outcomes, as the political response to deflation throughout Central Europe and Latin America destroyed the prevailing order, including several democracies.
Indeed, as governments scramble to respond to the current crisis, we should remember that deflation tends to produce not only radical anti-capitalism, but also a profound hostility to any kind of economic or political organization.
The conventional view of deflation is often justified by noting several important channels through which deflation can adversely affect an economy.
Unlike a collapse in aggregate demand, positive aggregate supply shocks that are not monetarily accommodated generate a benign form of deflation where nominal spending is stable, because the decline in the price level is accompanied by an increase in the actual and "natural" level of output.
Figure 1 illustrates these two distinct forms of deflation using the standard textbook aggregate demand-aggregate supply (AD-AS) framework.
Consequently, stable nominal wages, increasing real wages, and stable profit margins are fully consistent with productivity-generated deflation (Selgin 1997: 65).
As long as the deflation is being generated by productivity gains, there should be an offset from the real interest rate to prevent the nominal interest rate from hitting the zero bound.
Both the sticky-wage and debt-deflation stories relied on movements in the price level that were unanticipated when contracts were signed, while the interest-rate story is based on expected deflations.
Our analysis does suggest that price deflations may cause modest output declines.
Deflations in the range of 1 percent to 2 percent are more likely today, so interest-rate concerns are less relevant.
Although history suggests that large deflations are a cause for concern, this Commentary contends that occasional modest deflations (in the range of 1 percent to 2 percent annually) should little concern policymakers.
According to economic theory, deflation fuels expectations that prices will continue to fall, encouraging consumers, businesses and government to put off purchases, thus holding back growth.