Paul Krugman Explains Inflation and Deflation

Paul Krugman:

This is probably a good time to point out something that should be widely understood: inflation and deflation are not symmetrical. Four percent inflation does very little harm; four percent deflation is a disaster. Why? Three reasons:

1. The zero lower bound: you can always raise interest rates, but you can’t cut them below zero, so deflation means significantly positive real rates even in the depths of a slump, making monetary stabilization much harder if not impossible.

2. Nominal wage rigidity: it’s hard to get wage cuts — always has been, and always will be. So deflation messes up labor markets.

3. Debt: deflation is always contractionary, because it redistributes wealth to creditors and away from debtors, who are almost by definition more likely to be spending-constrained. And in the euro context this means that imposing deflation on debtor countries worsens the downward pressure on the European economy.

So European policy that requires deflation on the part of a large part of the zone is a real disaster.

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