Monetary Deflation, Intertemporal Discoordination, and the Capital Structure
We can examine the costs of deflation at a more microeconomic level by exploring the ways in which it affects the capital structure.
To see how this same theoretical apparatus might work for deflation, we have to imagine the banking system either intentionally reducing the money supply or not responding by expanding it when the public saves more.
The political response to deflation is to call for a stronger state.
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.
Most of the renewed interest in deflation has been premised on a belief that deflation is harmful to economic activity (Stern 2003).
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.
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.