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Deflation – Benign and Malevolent

May 29, 2017 Leave a comment

Just been covering this area with my AS class and below are some notes. First of all, we need to be clear as to what we mean by deflation. It is a fall in the general price level and must not be confused with falls in a few specific prices, such as for televisions and cars.

Economists distinguish between ‘benign’ deflation and ‘malevolent’ deflation.

‘Benign’ deflation usually stems from technological advances which bring down the price of products. Computer chips would be a good example and I am sure that you can think of others where goods that were initially very expensive have fallen in price as technology has progressed. As a result of the fall in these prices, real incomes have risen.

‘Malevolent’ deflation is the real problem. Here the money supply falls, aggregate demand falls and serious economic consequences may result.

The Consequences of Deflation
1  As aggregate demand falls, firms will find it difficult to sell their products, stocks will begin to rise and less production will be necessary. Firms may try at first to cut costs by wage reductions, but this strategy will be fiercely resisted by workers. The cuts, however, will become inevitable. Even this may not be sufficient and as the demand for goods and services falls, the demand for workers will fall and unemployment in the consumer goods and services industries will rise. The multiplier can work in reverse as well, so an initial fall in spending can trigger further falls in aggregate output.
2  Also, with consumer demand falling, firms will face decreased profits and also have poor expectations of future profitability. There is also a negative accelerator: falling GDP (a recession) hurts business profits, sales, cash flow, use of capacity and expectations. This in turn discourages investment.
3  As firms may have borrowed to invest in capital equipment in the past they will now be faced with the problem that the return on their capital spending is well below what they anticipated. With falling demand but borrowing costs rising in real terms as a result of falling prices, bankruptcies are likely to be a feature of deflation.
4  ‘Negative equity‘ is likely to depress consumer spending as people find that the value of their house falls and their debt or mortgage becomes larger in real terms.
It is the last that could be the real killer. Modern western economies have been built on an ever-rising quantity of debt. In the last decade, borrowers could rely on rising prices to inflate away the real value of their debts; now for the first time since the depression of the 1930s there is the looming threat of debt deflation, where the burden of debt grows bigger rather than smaller. It also means that real interest rates can’t be negative, and so are undesirably high. That spurs yet more repayment of loans so that the liquidation defeats itself.

In terms of policy, the risk of debt deflation will mean that economic policies remain looser for longer and even if inflation  remains low and recovery will be hesitant. However if the global economy fails to respond to the stimulus, they don’t have an awful lot left to offer. With deflation there is mention of a classic Keynesian liquidity trap.

The Liquidity Trap
This is a situation where monetary policy becomes ineffective. Cutting the rate of interest is supposed to be the escape route from economic recession: boosting the money supply, increasing demand and thus reducing unemployment. But John Maynard Keynes argued that sometimes cutting the rate of interest, even to zero, would not help. People, banks and firms could become so risk averse that they preferred the liquidity of cash to offering credit or using the credit that is on offer. In such circumstances, the economy would be trapped in recession, despite the best efforts of monetary policy makers.
The graph below shows a liquidity trap. Increases or decreases in the supply of money at an interest rate of X do not affect interest rates, as all wealth-holders believe interest rates have reached the floor.

liquid_trap
All increases in money supply are simply taken up
in idle balances. Since interest rates do not alter, the level of expenditure in the economy is not affected. Consequently, monetary policy under these circumstances is futile.

Final thought
Today the threat of deflation seems to have passed us by but the world was looking at a major global slowdown and it was not a matter of how much things were slowing, but it was how much they were going backwards. The most disconcerting fact was that all the easing of interest rates by central banks didn’t really change that outlook. Besides, with the severe threat of deflation there was a need to preserve the firepower in case the economy needed more stimulating. Like when an individual is besieged by many attackers while holding limited ammunition, each shot is used sparingly. But with little ammunition left what was next?

Categories: Deflation

Global Liquidity Trap

April 4, 2017 Leave a comment

The FT had an excellent article back in April last year that covered many concepts which are a part of Unit 4 of the CIE A2 Economics course. It covers the liquidity trap, deflation, MV=PT, circular flow, Monetary Policy, Quantitative Easing etc.

The article focuses on the liquidity trap with Monetary Policy being the favoured policy of central banks. However by pushing rates into negative territory they are actually encouraging a deflationary environment, stronger currencies and slower growth.  The graph below shows a liquidity trap. Increases or decreases in the supply of money at an interest rate of X do not affect interest rates, as all wealth-holders believe interest rates have reached the floor. All increases in money supply are simply taken up in idle balances. Since interest rates do not alter, the level of expenditure in the economy is not affected. Hence, monetary policy in this situation is ineffective.

Liquidity Trap

Normally lower interest rates lead to:

  • savers spending more
  • capital being moved into riskier investments
  • cheaper borrowing costs for business and consumers
  • a weaker currency which encourages exports

But when interest rates go negative the speed at which money goes around the circular flow (Velocity of Circulation) slows which adds to deflationary problems. Policymakers pump more money into the circular flow to try to stimulate growth but as price fall consumer delay purchases, reducing consumption and growth.

The article concludes by saying Monetary Policy addresses cyclical economic problems, not structural ones. Click below to read the article.

The global liquidity trap turns more treacherous.

Bank of Japan sits on its hands

May 15, 2016 Leave a comment

Central Bank Rates 6th May 2016Been teaching a lot on the problems that economies have in trying to stimulate more growth to get out of the deflationary threat that is prevalent in many countries. Central Banks around the world running are out of ammunition (cutting interest rates – see rates below) and one wonders what is the next step that economies can take?

Back in February the Bank of Japan (BOJ) pushed interest rates into negative territory with the uncollateralised overnight rate being -0.10%. After saying that it would do everything in its power to get inflation to reach 2% (its target rate) and with inflation expectations moving down from 0.8% to 0.5%, markets were very surprised that it didn’t ease rates further. Two of Japan’s measures of inflation are moving away from the the target rate of 2% – see graph below.

Japan inflation 2016

With this decision the Yen strengthened and it is becoming exceedingly difficult to tell if a central bank has run out of ammunition especially when it doesn’t fire a shot. So why have the BOJ held off on easing?

  1. When rates are cut – especially if they go negative – it takes six to twelve months to judge its impact on the economy. This is something referred to as the ‘Pipeline Effect’.
  2. Governor Haruhiko Kuroka may be concerned with the strengthening of the Yen after the last cut in February. This makes exports more expensive and imports cheaper.
  3. The Governor is waiting for the government fiscal stimulus to kick in with the impending cancellation of an increase in value-added-tax.

There is plenty of room to push interest rates further into negative territory and with the next scheduled BOJ meeting in June they will be watching what the US Fed reserve do. An increase in the US Fed rate will mean a stronger US dollar which might achieve more for Japan than further negative interest rates.

Low inflation in New Zealand not just about falling oil prices.

March 15, 2016 Leave a comment

The 0.1% inflation rate in New Zealand has largely been attributed to the 50% drop in oil prices since the start of last year – see chart. Although oil prices are referred to as a volatile item they have been low for sometime and are expected to remain subdued. Lower fuel costs have reduced prices for services such as air travel, and have dampened prices on shop floors as the distribution costs for retail items have declined.

World Commod Prices

However low inflation doesn’t just reflect movements in the price of oil. Even excluding petrol prices, inflation has been below 1% for most of the past year, and it’s set to remain low through 2016. The weak inflation figure has also been due to the low global inflation holding prices down and with the trend likely to continue for some time given the deterioration in global trade and widespread falls in commodity prices. Add to this the slowing growth of the Chinese economy and with its importance to global growth (see chart) you have a serious threat of deflation. This is particularly a concern if the Chinese authorities decide to further devalue their currency – the Renminbi. The RBNZ will have a tough job ahead of it to generate a sustained increase in inflation.

Screen Shot 2016-03-13 at 11.48.53 PM

Winners and Losers of lower oil prices

January 22, 2016 Leave a comment

With lower oil prices below is a table looking at the winners and losers.

Oil - Winners Losers

Categories: Deflation, Supply & Demand Tags:

Supply Side policies Chinese style

January 11, 2016 Leave a comment

The names of Reagan and Thatcher are identified with supply-side policies of the 1980’s in the US and the UK. Now the Chinese authorities are suggesting the need to implement supply side policies as the country looks poised to post its slowest annual economic growth rate in a quarter century.

During the 1980’s the concern in the US was production bottlenecks fuelling inflation and stifling growth. However, in contrast the Chinese have the opposite issues – excess production, the threat of deflation and unsustainably rapid growth. In classic supply-side economics, the government should reduce its role in economic activities, but in the Chinese context, the government will continue to play a big role in making supply-side changes.”

The differences between US and Chinese Supply Side Policies

US v China supply side

Categories: Deflation Tags: ,

Sweden’s negative interest rates.

November 15, 2015 Leave a comment

To boost spending in any economy you would assume that the central bank would reduce interest rates – encourages borrowing and reduces saving. But very low interest rates could encourage people to hold cash rather than keep the money in the bank – this could slow economic activity in the economy.

Sweden’s central bank – Riksbank – has gone negative with interest rates. Sweden has the third highest savings rate in the developed world but there is a significant positive output gap. With inflation at 0.2% it remains well below the central bank’s 2% target but the mandate from the Swedish government encourages radical measures to rectify the threats of deflation. 

But with lower rates in the eurozone to stimulate growth this has weakened the Euro against the Swedish krona making Swedish imports cheaper and putting further deflation pressure on the economy. Therefore the Riksbank has had to cut its own rates in response in an attempt to avoid deep deflation. Switzerland has also go the negative way with a rate of -0.75%.

Swedish Interest Rates

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