Question

1. At the end of Chapter 12, Mankiw presents an analysis of six separate costs of inflation: shoe-leather costs, menu costs, relative-price variability and the mis-allocation of resources, inflation-induced tax distortions, confusion and inconvenience, and arbitrary redistributions of wealth. If inflation leads to these problems, does it follow that deflation (the opposite of inflation, falling prices) makes these costs disappear. Put more generally, if inflation is bad, does it follow that deflation is good?

2. Using the "six costs of inflation" detailed by Mankiw, explain the likely effects of deflation. In responding, comment briefly on each of the six costs identified by Mankiw.

3. Are there other consequences of deflation (not included in the six costs identified by Mankiw) that we should fear as consequences of a substantial deflation? [Hint: Think about the consequences of running a highly-leveraged business during a decade of deflation in which the price level declines by an average of 5 percent each year. (A highly-leveraged business is one where much of your working capital is borrowed.) As a consequence of this debt, you have large monthly debt-service (principal and interest payments) obligations that were fixed in their dollar amount at the time the borrowing was arranged. How do you stay in business if the average price of your product is declining each year by say 5 percent, while at least one of your costs (debt-service payments) does not change?]

You might find the following piece by Paul Krugman to be useful in understanding the effects of deflation: Fear of a Quagmire, New York Times, 5-23-03. [This Krugman piece is a bit dated now, but the problems associated with falling prices is a lesson well learned whether the threat is immediate or not.]

Answer 1

Answer 1;

Deflation leads to fall in the cost of various products in the market. It reduces cost for the producers but in the long run it is an overall decline in prices and fall in the prices ultimately leads to fall in the profits of the producers as total revenue of the producers fall. This induces them to produce less and there is fall in national output and also fall in the growth rate of national output in the economy. Thus, inflation within a targeted limit is not bad. Persistent fall in the prices of goods is not always good for the economy.