Thursday, August 14, 2008

Benign Deflation in a New Keynesian Model

As readers of this blog know, I am a advocate of monetary policy adopting a more nuanced view of deflation. Currently, most observers view any deflationary pressures as something to be avoided at all costs. This conventional wisdom assumes all downward price level pressures are economically harmful and, thus, fails to distinguish between between aggregate demand-induced deflationary pressures and aggregate supply-induced deflationary pressures. As a result, central bankers are likely to add monetary stimulus during periods of rapid economic growth--for example, when a positive productivity shock increases aggregate supply--in the mistaken belief that the deflationary pressures indicate economic weakness. Such actions, in turn, can generate a boom-bust cycle in economic activity. As I have argued elsewhere (here, here, here), the Fed's easy money in 2003-2005 in one such example.

Given these views of mine, I was pleased to come across Niloufar Entekhabi's new article, "Technical Change, Wage and Price Dispersion, and the Optimal Rate of Inflation." In it, Entekhabi uses a standard New Keynesian model to find the optimal rate of inflation and it turns out to be negative. One innovation of the paper is that it incorporate non-zero long-run growth in the model. From his conclusion:
This paper shows that adding real growth to the New Keynesian models is a very important feature, missing from the studies of these models. Real growth brings the arguments of price deflation rate as an optimal policy back to the policy discussion. In this research, real growth is added to a simple New Keynesian model with both price and wage rigidities. In such an environment, the economy faces four types of distortions, due to the imperfect nature of markets and the staggered contracts. Then, the Pareto optimal level of output is no longer attainable. The optimal policy is considered as the optimal rate of inflation which the central bank should target to minimize the distortions in the economy. In our experiment and under a wide range of parameter values and calibrations, this rate reveals to be slightly negative and therefore, deflation is the optimal policy... The results favor the old view in the monetary policy literature that a slight level of deflation is optimal. These results are very useful for policy analysis and show the path for the future research.
I had been meaning to do something like this paper after the reading the other New Keynesian-type analysis that also finds benign deflation might be optimal. This other paper, though, finds benign deflation to be optimal in the terms of minimizing asset boom-bust cycles. In case you missed it, here is part of my post on that research:
Lawrence Christiano, Roberto Motto, and Massimo Rostagno have a new NBER working paper titled "Two Reasons Why Money and Credit May be Useful in Monetary Policy." I find this article interesting because one of the reasons the authors cite for taking money and credit seriously in monetary policy--as opposed to standard New Keynesian analysis that sees little role for money--is that focusing "narrowly on inflation [alone] may inadvertently contribute to welfare-reducing boom-bust cycles in real and financial variables." The authors show that if (1) there are positive productivity innovations and (2) monetary policy follows a standard Taylor rule that responds to deviations of inflation from its target then boom bust cycles in asset prices can be generated.

The authors explain that in "the equilibrium with the Taylor rule, the real wage falls, while efficiency dictates that it rise [following a productivity shock]. In effect, in the Taylor rule equilibrium the markets receive a signal that the cost of labor is low, and this is part of the reason that the economy expands so strongly. The ‘correct’ signal would be sent by a high real wage, and this could be accomplished by allowing the price level to fall. However, in the monetary policy regime governed by our Taylor rule this fall in the price level is not permitted to occur: any threatened fall in the price level is met by a proactive expansion in monetary policy."

In other words, these authors are arguing that by not allowing for benign deflation--deflation generated by productivity innovations--monetary authorities are generating too much liquidity and, in turn, fueling asset price boom-bust cycles.
I hope to see many more papers like these ones on the macroeconomic implications of benign deflation. I have a few related projects in the pipeline and I believe Josh Hendrickson does as well. Maybe George Selgin and the folks at the BIS--see William White's classic "Is Price Stability Enough?"--can also push some more papers out on this topic.


  1. In addition to boom/bust cycles, money expansion driven inflation regressively redistributes resources to those first in line to receive the newly created money. Its no accident that a single median wage is no longer sufficient to support a family, and the decline started during the high inflation period.

    Savings are also discouraged (we have no net domestic savings), so workers don't have enough to fall back on when they retire. Retirees are then further savaged by inflationary confiscation of their pensions, and meager savings.

  2. JUST FOR FUN -- If things go the way I'd like them to we wont have to be concerned with deflation for a while:
    How much added inflation NECESSARY to reset income share?

    Deep progressive thinker, Thomas Palley, surprisingly seems not to have calculated any specific path at all to reshaping US income share when he wrote: "...since inflation involves conflict over income distribution, there remains an unsolved policy challenge of how to fairly distribute income at full employment without triggering inflation."*

    How can we possibly redistribute the 12.4% of income share that migrated from bottom 90 percentile earners to top 3-4% earners over the past three and a half decades without adding at least 12.4% price inflation to regular inflation -- and even more due to round-robin adjustments as the bottom 90 percentile sort and re-sort their relative shares (shifting income in the same way that inflation shifts wealth from creditors to debtors -- and deflation vice-versa)?

    Not all in one year of course.

    The need to use inflation to reset overall income share becomes immediately obvious once you begin to work through the most likely steps to produce that result: minimum wage doubling (with mandatory inflation adjustments below $100,000/yr?) and sector-wide labor agreements.

    An at least a temporary marginal tax hike might have to be thrown in (5% price inflation wont take back enough of incomes that multiplied 2500% over the last 35 years) to douse decades of overbuilt compensation expectations at the top.

    The Fed would need be to brought on board, to understand that this is one-time price inflation deliberately calculated to reset 35 years of wage deflation. I just read on p. 150 of Chang’s Bad Samaritans: "...even many neo-liberal economists admit that, below 10% inflation does not seem to have any adverse effect on economic growth." If necessary, a recession can be induced when it is all over to reduce built-in inflationary expectations -- a small price to pay for ending a 35 year "wage depression."

    What worries me is that if deep thinking, practical Palley has not thought through the simple concrete steps to a fair economy, then probably, most of the other top thinkers never do either. Maybe it is the seeming impossibility of any immediate income reset as long as a mentally retarded administration rules in Washington.

    I am sure top progressive thinkers would eagerly support both minimum wage doubling w/inflation guarantees and sector-wide labor agreements as the most obvious path from living-to-work to working-to-live for the majority of Americans if the two happened to be current big political footballs. Someone ought to tell top progressive thinkers that unless they get real busy and inform the world of the possibility of what (I hope) would be their two favorite programs, the two (or three: temp tax) will never become big political footballs.


  3. I recently came across a nice model that finds the optimal rate of inflation ranging from -4,2% to -0,4% a year. See Schmitt-Grohé and Uribe (2007), "Optimal Inflation Stabilization in a Medium-Scale Macroeconomic Model" (