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Friday, August 6, 2010

Is there such a thing as a "benign" deflation...

The Cato Institute thinks so, and has published a paper on the subject.  Basically a benign deflation is one that is caused by an increase in aggregate supply (as opposed to the more familiar malign deflation that is driven by a collapse in aggregate demand).  They go on to argue that such benign deflations are optimal, etc, etc...

The Cato institute points out that within the standard AD-AS model, deflation can come about following an increase in aggregate supply that are not accomodated by an easing in monetary policy. 
"Such aggregate supply shocks are the result of positive innovations to productivity or factor input growth that lower per unit costs of production and, in conjunction with competitive market forces, create downward pressure on output prices. 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."
They go on to make the following arguement: if we are experiencing deflation now, then it is clearly the benign form of deflation, that it is optimal, and that governments everywhere shouldn't fight it.  They mention something about China and India being positive shocks to aggegate supply I be honest my attention span began to wane...I kept trying to work out how this view could be consistent with the empirically documented high amount of slack/under-utilized capacity in the economy...I am pretty sure that it isn't consistent...but this would not be the first time that the Cato Institute has published something inconsistent with reality but consistent with their political agenda.  I don't doubt that deflation driven by an increase in aggregate supply is possible, nor do I doubt that one can find historical examples of such a deflationary event...I do however doubt that a benign deflation is what we are about to experience.

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