DP3869 Deflation: Prevention and Cure

Author(s): Willem H. Buiter

Publication Date: April 2003

Keyword(s): deflation , zero bound , policy effectiveness

JEL(s): E31 , E62 , E63 , F41

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP3869.asp

After an absence of almost half a century, the spectre of deflation is once again haunting the corridors of central banks and finance ministries in the industrial world. While preventing or combating deflation poses some unique difficulties not present in preventing or combating inflation, deflation can be prevented and, if it has taken hold, can be overcome, using conventional instruments of monetary and fiscal policy. These include open market purchases of government securities and monetary financing of government deficits caused by expansionary fiscal measures. Base money-financed tax cuts or transfer payments – the mundane version of Friedman’s helicopter drop of money – will always boost aggregate demand. Unconventional monetary and fiscal measures are also available. These include open market purchases of private and foreign securities, negative nominal interest rates (through a carry tax on currency) and intertemporal terms of trade shifting temporary tax measures aimed at shifting private consumption from the future to the present, such as a cut in VAT today coupled to the credible commitment of a VAT increase in the future. Such measures may be helpful, but are not necessary to get the job done. Deflation results from a combination of bad luck and poor economic management, including the failure to coordinate monetary and fiscal policy. Sustained unwanted deflation is evidence of policy failure. Both the knowledge and the tools exist to prevent unwanted deflation.