Monday, February 24, 2014

Deflation: An Intermediate Exercise

There is much talking about deflation lately in both sides of the Atlantic. How probable deflation is? How did we get to worry about negative price developments while last year some economists (fortunately, not too many) were arguing for the risk of high inflation as a result of the expansionary monetary policy? 

10 months ago Paul Krugman was looking for the "Missing Deflation", and I made an attempt (with some mistakes...) to find it. Currently, energy cost evolution is weak (Eurostat) and growth in the EMU remains feeble, while the US are getting better.

I will attempt to explain the recent deflationary pressure through a Medium term Aggregate Demand - M/term Aggregate Supply (AD-AS).  In Figure 1, economy's midterm equilibrium is at point A, where AD and AS intersect over the Full Employment locus- that was back in 2007. The negative aggregate demand shock following the Great Recession of 2008 is represented by the shift of AD to AD', where the expected price level, Pe (intersection of AS and Potential Output), is greater than medium-term realized price level, P* (intersection of AS and AD'). AS curve gradually adjusts, moving towards point A'. That is where things become different for the US and the EMU.

Figure 1

EMU: In Figure 2 we observe the faint growth rates, which means that AD' has remained below the pre-2008 level for the entire medium-term horizon, giving enough time to AS to adjust, ultimately leading to a lower price level - i.e. deflation. The policy mixture in the Eurozone: austerity for most countries and fairly expansionary monetary policy.
US: Persistently higher growth rates have allowed AD to recover closer to its pre-2008 level, preventing strong negative price adjustment to take place. The policy mixture in the US: aggressively expansionary monetary policy and budget deficits- however, the letter has decreased more than a half over the last two years, from 8.4% of GDP in 2011 to 4.1% in 2013 (cbo.gov).

Figure 2

Overall, it is safe to conclude that the deflation risk has nothing surprising in it, as far as the EMU is concerned. On the other hand, the risk for the US is very low. 
While we are waiting for the ECB to take action, let us see what we can expect from our central bank. AD curve of the medium-run is determined by the IS-LM framework of the short run. In 2008 IS shifted to IS', leading to a lower product, while LM gradually moved to LM' - the zero lower bound, a liquidity trap. Again two different cases for he EMU and the US.

EMU: Eurozone economic activity has remained close to IS' (due to the policy mixture aforementioned) for a long period - the problem extended to the medium term - and ECB monetary policy is very close (if not in) to the zero lower bound. Any QE will have very little if any effect in shifting IS' towards IS for two reasons. Firstly, any shift from LM' to LM'' will not affect the interest rate since LM curve of the ECB is practically flat. Secondly, interest rates (both expected and realized) abroad are also close to zero and we should not expect any depreciation to enhance exports even more. Therefore, under the ongoing state of affairs IS' will keep recovering towards IS at a slow pace, and, hence, AD' will remain well below 2008 level over the medium term; price level will keep decreasing. Only shifts of the IS can increase product at a higher rate to halt further negative price adjustments.
US: Economic activity recovered at a faster pace than in the Eurozone, and AD did not remained for too long far from the pre-2008 level. Monetary policy remains, also, ineffective. 
Figure 3

In conclusion, deflation is more likely to appear in the Eurozone than in the US, and any ECB action will find it difficult to tame the inimical price developments. Intermediate Macroeconomics models are not that bad in the end, are they?

For more on IS-LM (Mundell-Fleming) and AS-AD frameworks (These are my references, as well - Errors, naturally, mine):
[1] http://ocw.mit.edu/courses/economics/14-02-principles-of-macroeconomics-fall-2009/lecture-notes/
[2] Blanchard, O. and Johnson, D. R. (2013): "Macroeconomics". Pearson. 6th Edition.
[3] Burda, M. and Wyplosz, C. (2009): "Macroeconomics: A European Text". Oxford UP. 6th Edition.
And in many more...

*Updated graphs on Febr. 13, 2015. They had gone missing...