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Deflation: Prevention and Cure

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  • Buiter, Willem H

Abstract

After an absence of almost half a century, the spectre of deflation is once again haunting the corridors of central banks and finance ministries in the industrial world. While preventing or combating deflation poses some unique difficulties not present in preventing or combating inflation, deflation can be prevented and, if it has taken hold, can be overcome, using conventional instruments of monetary and fiscal policy. These include open market purchases of government securities and monetary financing of government deficits caused by expansionary fiscal measures. Base money-financed tax cuts or transfer payments – the mundane version of Friedman’s helicopter drop of money – will always boost aggregate demand. Unconventional monetary and fiscal measures are also available. These include open market purchases of private and foreign securities, negative nominal interest rates (through a carry tax on currency) and intertemporal terms of trade shifting temporary tax measures aimed at shifting private consumption from the future to the present, such as a cut in VAT today coupled to the credible commitment of a VAT increase in the future. Such measures may be helpful, but are not necessary to get the job done. Deflation results from a combination of bad luck and poor economic management, including the failure to coordinate monetary and fiscal policy. Sustained unwanted deflation is evidence of policy failure. Both the knowledge and the tools exist to prevent unwanted deflation.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 3869.

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Date of creation: Apr 2003
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Handle: RePEc:cpr:ceprdp:3869

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Keywords: deflation; policy effectiveness; zero bound;

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Cited by:
  1. John H. Cochrane, 2009. "Comment on "On the Need for a New Approach to Analyzing Monetary Policy"," NBER Chapters, in: NBER Macroeconomics Annual 2008, Volume 23, pages 427-448 National Bureau of Economic Research, Inc.
  2. Truger, Achim & Schulten, Thorsten & Hein, Eckhard, 2004. "Wage trends and deflation risks in Germany and Europe," WSI Discussion Papers 124, Wirtschafts- und Sozialwissenschaftliches Institut (WSI), Hans-Böckler-Stiftung.
  3. Taimur Baig, 2003. "Understanding the Costs of Deflation in the Japanese Context," IMF Working Papers 03/215, International Monetary Fund.
  4. Joerg Bibow, 2004. "Fiscal Consolidation Contrasting Strategies & Lessons from International Experience," Macroeconomics 0402014, EconWPA.
  5. Buiter, Willem H, 2003. "Two Naked Emperors? Concerns about the Stability and Growth Pact and Second Thoughts About Central Bank Independence," CEPR Discussion Papers 4001, C.E.P.R. Discussion Papers.
  6. Alfonso Palacio-Vera, 2006. "On Lower-bound Traps: A Framework for the Analysis of Monetary Policy in the ÒAgeÓ of Central Banks," Economics Working Paper Archive wp_478, Levy Economics Institute.
  7. Gauti B. Eggertsson, 2006. "Fiscal multipliers and policy coordination," Staff Reports 241, Federal Reserve Bank of New York.
  8. Romain Veyrune, 2005. "Le prix de la fixité : Application à l'Union monétaire des Caraïbes orientales et à la Zone franc," Mondes en développement, De Boeck Université, vol. 130(2), pages 63-76.
  9. Junning Cai, 2004. "Liquidity Trap Prevention and Escape: A Simple Proposition," Macroeconomics 0402033, EconWPA.
  10. von Hagen, Jürgen & Hofmann, Boris, 2003. "Macroeconomic implications of low inflation in the euro area," ZEI Working Papers B 29-2003, ZEI - Center for European Integration Studies, University of Bonn.
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