No. 268 - Is deflation good or bad? Just mind the inflation gap

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 owing to the presence of constraints in the economy, namely the zero lower bound on nominal interest rates, borrowing limits, and downward nominal wage rigidity. When these constraints are binding, they can prevent monetary policy from closing the inflation gap, agents from deleveraging, and the labor market from clearing. The impact of a disinflationary shock on the tightness of these constraints depends on the cyclical and structural conditions of the economy. We also argue that it would be a mistake to assume that perverse effects can arise only when prices decrease, and that the classification of deflationary episodes into good (supply driven) and bad (demand driven) is not only incorrect, it is also misleading in terms of policy implications.