Is Deflation Good or Bad? Just Mind the Inflation Gap

16 Pages Posted: 23 May 2015

See all articles by Marco Casiraghi

Marco Casiraghi

Bank of Italy; International Monetary Fund (IMF) - International Capital Markets Department

Giuseppe Ferrero

Bank of Italy

Date Written: April 23, 2015

Abstract

We explain why the macroeconomic effects of shocks to inflation of the same size, but opposite sign, are not necessarily symmetric. All in all, the costs of deflation and disinflation tend to exceed those of inflation due to the presence of constraints in the economy, namely the zero lower bound on nominal interest rates, downward nominal wage rigidity and borrowing limits. When these constraints are binding, they can prevent monetary policy from closing the inflation gap, labor market from clearing and agents from deleveraging. The impact of a disinflationary shock on the tightness of these constraints depends on the cyclical and structural conditions of the economy. We argue that it would be a mistake to assume that perverse effects can arise only with actual deflation and thus that the classification of deflationary episodes into good (supply-driven) and bad ones (demand-driven) is not only incorrect, but also misleading in terms of policy implications. Empirical evidence for the euro area suggests that the three constraints have become increasingly tight recently.

Keywords: monetary policy, unconventional monetary measures

JEL Classification: E31, E52, E58

Suggested Citation

Casiraghi, Marco and Casiraghi, Marco and Ferrero, Giuseppe, Is Deflation Good or Bad? Just Mind the Inflation Gap (April 23, 2015). Bank of Italy Occasional Paper No. 268, Available at SSRN: https://ssrn.com/abstract=2609286 or http://dx.doi.org/10.2139/ssrn.2609286

Marco Casiraghi

Bank of Italy ( email )

Via Nazionale 91
Rome, 00184
Italy

International Monetary Fund (IMF) - International Capital Markets Department ( email )

700 19th Street NW
Washington, DC 20431
United States

Giuseppe Ferrero (Contact Author)

Bank of Italy ( email )

Via Nazionale 91
Rome, 00184
Italy

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