Download deflation/disinflation

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So far we have talked about efforts to reduce unemployment. What about an effort that would reduce inflation?
The government must create a situation, with contractionary fiscal/monetary policy, where the unemployment rate is above NAIRU. This induced recession should decrease the inflation rate to the point where the SRPC shifts downward. Once inflation is under control, the economy can adjust back to NAIRU. This process of disinflation is painful because of a period of high unemployment. 2
Why is deflation a problem? And why is it hard to end? Would you like it when price levels fall?
Deflation, like inflation, produces winners and losers, but in the opposite direction. Due to the falling price level, a dollar in the future has a higher real value than a dollar today. So lenders, who are owed money, gain under deflation because the real value of borrowers’ payments increases. Borrowers lose because the real burden of their debt rises.
What can you expect borrowers to do? Cut back on spending. So weak spending causes deflation, which causes deflation, which causes less spending, which causes deflation…
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We have already seen that interest rates are affected by inflation expectations. What about deflation?
Nominal rate = real rate + expected inflation
Suppose the rr=2% and expected inflation = 3%, then the nominal rate = 5% (Draw example of Fisher Effect in Loanable Funds market)
But what if there is prolonged deflation and the expected inflation is ‐2%
But what if there is prolonged deflation and the expected inflation is 2%, then the nominal then the nominal
rate is 0%. (Now draw a shift downward of equilibrium to the horizontal axis, at 0% interest rate. What if deflation continued? Could we continue to go down?)
Interest rates cannot fall below 0%, therefore they are zero bound. So deflation creates a situation where lenders receive nominal interest rates that approach zero. Lending will stop.
If the economy is extremely depressed, which caused the deflation in the first place, monetary policy becomes completely ineffective. The Fed can’t lower the interest rate lower than 0%!! This kind of deflation can cause an economy to languish for a very long time. This is referred to as a liquidity trap.
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