Three great American disinflations

While there is substantial evidence that deflations or disinflations are often quite costly, there is less
agreement about what factors contributed to high real costs in some episodes, or why some deflation epsiodes are most costly than others. Clearly, a better understanding of the factors that influence the costs of monetary contractions matters for monetary policy.

A new paper by Michael Bordo, Christopher Erceg, Andrew Levin, and Ryan Michaels, Three Great American Disinflations (PDF), tries to shed light on the issue by examining three famous episodes of deliberate deflation or disinflation in US history, including episodes following the Civil War, World War I, and the Volcker disinflation of the early 1980s. These episodes, which were associated with widely divergent effects on the real economy, were analyses within the context of a stylized DSGE model. Here's what they found:

Our model simulations suggest that the relatively robust output growth that occurred during the post-Civil war deflation of the 1870s was facilitated by the highly predictable nature of the price decline. By analogy, a more predictable policy of gradual deflation could have helped avoid the sharp post-WWI downturn.

However, our analysis of the Volcker period emphasizes that the strong argument for gradualism that is apparent under a transparent and credible monetary regime becomes less persuasive if the monetary regime lacks credibility: in the latter case, gradualism may simply serve to prolong the suffering associated with a disinflationary episode.

Thus, securing the benefits of gradualism requires a supporting institutional framework and communication strategy that allows the private sector to make reliable inferences about the
course of policy.

Our model simulations indicate how a more predictable policy of gradual deflation could have helped avoid the sharp post-WWI depression. But our analysis also suggests that the strong argument for gradualism under a transparent monetary regime becomes less persuasive if the monetary authority lacks credibility; in this case, an aggressive policy stance (as under Volcker) can play a useful signalling role by making a policy shift more apparent to private agents.

So gradualism - "a more predictable policy of gradual deflation" - only works well when monetary authorities already have credibility. Without that, "an aggressive policy stance (as under Volcker) can play a useful signalling role by making a policy shift more apparent to private agents."

This is one of the papers delivered last week to the fourth International Research Forum on Monetary Policy in Washington, DC. Organised by the Federal Reserve, ECB, Goethe and Georgetown Universities, it featured some high-level particpants and papers.

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