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Classical economics and deflation

Posted on | February 5, 2009 | Comments Off by Aschwin de Wolf

A 2004 research paper by the Federal Reserve Bank of Richmond on Classical Deflation Theory concludes as follows:

Of course, deflation under certain circumstances might not be a bad thing, that is, might have no adverse real effects. If so, policymakers could ignore it or implement it with impunity. Such would be the case for deflations that (1) are always fully expected, 2) occur in a setting of complete wage-price flexibility, and (3) stem from productivity-induced growth in aggregate supply rather than monetary-induced contractions in aggregate demand. With the possible exception of Hume, however, classicals paid insufficient attention to these considerations and left their discovery to their neoclassical successors.

Since the conditions under which deflation might not be “such a bad thing”  can be captured  by classical ecomic theory in which (a) markets clear and (b) agents act in their self interest (see Robert Lucas on Equilibrium Business Cycle Theory), one would expect that the Rational Expectations and New Classical Macroeconomics counter-revolutions would have inspired a renewed look at the orthodox views on deflation. Some of the prevailing theories about  the harmful effects of deflation appear difficult to reconcile with the postulates of classical economic theory. But so far most heterodox views on deflation seem to come from the Misean school of Austrian Economics.

Category: Economics
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