South-Western College Publishing - Economics  
Deflating Fears of Deflation
Subject Deflation
Topic Employment, Unemployment, and Inflation
Key Words Deflation, Federal Reserve, Productivity
News Story

Is deflation, a decrease in the average level of prices, a possibility? Alan Greenspan, chairman of the Federal Reserve, recently stated that deflation from the Far East is heading our way. Energy prices have decreased by about 10 percent from last year and commodity prices have dropped even more. Does this portend a deflation in the order of magnitude of the Great Depression? Does deflation signal a depression? Fears of deflation have recently generated some concern.

The last time the American economy experienced a deflation was during the Great Depression. Wages and prices fell precipitously and the unemployment rate rose to 25 percent of the labor force. The Federal Reserve abetted the deflation by doing nothing while banks failed and the money supply shrank.

Some prices have been dropping. The prices of imported goods have fallen in part as the result of Asia's economic problems, but not all prices have dropped. The Consumer Price Index continues to increase at a modest 2 percent. The Producer Price Index, excluding volatile energy and food prices is increasing at 1 percent per year. Importantly, wages have been rising at about 4 percent for this year. Since labor costs account for approximately two-thirds of the cost of goods and services, increasing wage costs without corresponding improvements in productivity make it difficult to lower prices. Productivity increases amounted to 2 percent last year.

Sustained deflation is a monetary event. Just as sustained inflation requires an increase in the money supply, a significant deflation would need to be supported by a drop in the money supply. During the Great Depression the Federal Reserve did not adopt measures to increase the money supply in the face of a number of bank failures. There is no reason to believe that the current Fed would adopt such a passive policy.

It does not seem likely that deflation will be a problem. While some prices are decreasing, the average of price increases and decreases--the Consumer Price Index--is growing. Since wages are increasing, there is substantial upward pressure on prices. Finally, it is likely that the Federal Reserve will not support a deflation.

(Updated December 1, 1998)
Questions

1. What is deflation? How should it be defined?
2. If productivity increases, can wages increase without an increase in prices? Explain your answer.
3. Suppose that the Federal Reserve wanted to increase the money supply in the face of a deflation. How could the Fed accomplish this?

Source Michael M. Weinstein, "Economic Scene: Deflation is frightening, but toothless, for 90's Americans", The New York Times, November 5, 1998.

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