Rethinking Deflation and its Effects: Lessons from Canada Under the Classical Gold Standard

Abstract

Deflation has a bad reputation. Economists often associate it with depression and fear that it could lead to financial disintermediation and reduce interest rates to their effective lower bound. Must deflation always lead to these outcomes? We argue that the answer is no. Using Canada's experience with sustained deflation under the classical gold standard, we show that economic growth was robust, financial intermediation increased, and interest rates remained well above zero. Using a structural vector autoregression, we also show that aggregate demand and gold price shocks affected output and real wages, implying some nominal wage rigidity. Our results show that even where there are nominal rigidities, sustained deflation is not necessarily a problem, and thus, central banks should not treat all deflation the same. Overall, our paper provides support for nominal income and flexible average inflation targeting by showing that there is no harm in policymakers ``looking through'' the effects of supply shocks on the price level.

Keywords: Canada, Deflation, Gold Standard, Nominal Rigidities, Structural Vector Autoregression

JEL Classification: E31, N11, O51