Are deflation and depression empirically linked? No, concludes a broad historical study of inflation and real output growth rates. Deflation and depression do seem to have been linked during the 1930s. But in the rest of the data for 17 countries and more than 100 years, there is virtually no evidence of such a link

Atkeson, A

Kehoe, PJ

UCL Discovery

Federal Reserve Bank of MinneapolisResearch Department St aﬀ Re p or t 331January 2004Deflation and Depression:Is There an Empirical Link?Andrew Atkeson∗University of California, Los Angelesand Federal Reserve Bank of MinneapolisPatrick J. Kehoe∗Federal Reserve Bank of Minneapolisand University of MinnesotaABSTRACTAre deflation and depression empirically linked? No, concludes a broad historical study of inflation and realoutput growth rates. Deflation and depression do seem to have been linked during the 1930s. But in the restof the data for 17 countries and more than 100 years, there is virtually no evidence of such a link.∗The authors thank Kathy Rolfe for excellent editorial assistance. The views expressed herein are those of the authorsand not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve Bank of Minneapolis.According to standard economic theory, deflation is the necessary consequence of optimal monetarypolicy. In 1969, Milton Friedman argued that under the optimal policy, the nominal interest rateshould be zero and the price level should fall steadily at the real rate of interest. Since then,Friedman’s argument has been confirmed in a formal setting. (See, for example, V. V. Chari,Lawrence Christiano, and Patrick Kehoe 1996 and Harold Cole and Narayana Kocherlakota 1998.)Most policymakers, however, are extremely reluctant to implement any policy that wouldlead to deflation. This reluctance seems to stem from the experience of the Great Depression, inwhich deflation and depression appear to have been tightly linked. (See, for example, Ben Bernankeand Kevin Carey 1996.) That experience has led to theories in which deflation leads to depression.The quantitative ability of those theories to account for the Great Depression is now being debated.(See, for example, Cole and Lee Ohanian 2001.)Here we examine the empirical relationship between deflation and depression in a broadhistorical context, including but not limited to the Great Depression. We use a panel data set oninflation and real output growth for 17 countries and more than 100 years. To focus on medium-term fluctuations, we break the time series on inflation and real output growth for each countryinto five-year episodes, and for each episode, we compute the average annual inflation rate and theaverage annual real output growth rate. For any episode, we define a deflation as a negative averageinflation rate and a depression as a negative average real output growth rate. Throughout, werestrict attention to moderate inflations, those with average annual inflation below 20 percent.Our main finding is that the only episode in which we find evidence of a link between de-flation and depression is the Great Depression (1929—34). We find virtually no evidence of sucha link in any other period. Here we have made no attempt to distinguish anticipated from unan-ticipated deflations, while theory, of course, makes a sharp distinction. Optimal monetary policyin a broad class of models with nominal rigidities dictates engineering small anticipated deflationsand avoiding unanticipated deflations altogether. To the extent that the deflation in the GreatDepression is thought of as unanticipated, as in most existing theories, this episode is not relevantfor evaluating the costs of anticipated deflation. Our finding thus suggests that policymakers’ fearof anticipated policy-induced deflation that would result from following, say, the Friedman rule isgreatly overblown.We note here that since WWII, one country has come close to having both a depression anda deflation: Japan in the late 1990s. Is Japan’s recent slowdown from a historically high averagegrowth primarily due to its very low inflation rates? We doubt it. Since 1960, Japan’s averagegrowth rates have basically fallen monotonically, and since 1970, its average inflation rates havetoo. Attributing this 40-year slowdown to monetary forces is a stretch. More reasonable, we think,is that much of the slowdown is the natural pattern for a country that was far behind the worldleaders and had begun to catch up.I. The DataAll of our series end in 2000. Here are the countries (and the years their data start): Argentina(1885), Australia (1862), Brazil (1861), Canada (1870), Chile (1908), Denmark (1871), France(1820), Germany (1830), Italy (1867), Japan (1885), the Netherlands (1900), Norway (1865), Portu-gal (1833), Spain (1849), Sweden (1861), the United Kingdom (1870), and the United States (1820).For all countries except Australia and Denmark, the data up to 1980 are taken from Arthur Rolnickand Warren Weber (1997). The data for Australia and Denmark up to 1980 are taken from DavidBackus and Kehoe (1992). The data for 1980 on are from the International Financial Statistics ofthe International Monetary Fund. (The pre-1980 data are missing some observations.)We choose the five-year episodes to start and end with years ending in 9 or 4. This way,we include the Great Depression of 1929—33 in a single episode covered by the five-year average of1929—34 and the depression of 1921—22 in the five-year average of 1919—24.2II. The FindingsA. The Great Depression EpisodeWe start with the Great Depression episode, 1929—34. The data for this episode do seem to show alink between deflation and depression–but not an overwhelmingly tight link.In Figure 1, we plot average inflation and output growth for the 16 countries for which we havedata for this period. (Chile’s output data are missing.) In 1929—34, all 16 countries had deflation, 8had deflation and depression, and the other 8 had deflation but no depression. For all 16 countries,a regression of output growth on a constant and the inflation rate has a slope coeﬃcient of .40 (.28).(Here, and throughout, we record the standard error of a regression coeﬃcient in parentheses.) Theslope coeﬃcient implies that, on average, a one percentage point lower inflation rate is associatedwith a drop in growth of .4 of a percentage point, say, from 3.40 to 3.00 percent. (We summarizeall our regressions in Table 1.)In the Great Depression episode, then, all countries had deflation, and half of them haddepression. In a regression sense, there seems to be a link here. Researchers disagree on how strongthat link is. Some, like Barry Eichengreen and Jeﬀrey Sachs (1985) and Bernanke and Carey (1996),argue that deflation and depression during the Great Depression were closely linked; Cole, Ohanian,and Leung (2003) argue to the contrary.B. Outside the Great DepressionWhile the debate about the Great Depression episode is ongoing, our interest lies mainly in lookingfor a robust relationship in a broader historical context. If we find none, the Great Depression mayhave been a special experience with little to oﬀer policymakers considering a deflationary policytoday. And that is what we find.In Figure 2, we plot average inflation and output growth rates for the 17 countries for allfive-year periods except 1929—34. Here we see only 8 episodes with both deflation and depression.3There are 65 episodes of deflation without depression and 21 of depression without deflation. Thus,65 of 73 deflation episodes had no depression, and 8 of 29 depression episodes had no deflation.What is striking is that nearly 90% of the episodes with deflation did not have depression. In abroad historical context, beyond the Great Depression, the notion that deflation and depression arelinked virtually disappears.Note that most of the episodes in the data set that have deflation and no depression occurredunder a gold standard; does that somehow make them irrelevant for shedding light on deflationsunder a fiat system? No. If we interpret such standards as a rule with some commitment, as many(like Bordo and Finn Kydland 1995) do, then these episodes seem at least as relevant for thinkingabout the eﬀects of following a Friedman rule as are the episodes in the post-WWII data, whenpolicy was more discretionary. And if we think that the world economy has changed so much sinceWWII that all the data before it sheds no light on what might happen in an economy today, thenthere is not much to discuss, since in the post-WWII period, there are no episodes of deflation.Moreover, as has been commonly noted, inflation is actually negatively related to output growth inthe post-WWII data.A more compelling objection is that the data from periods of world wars are just not relevantfor other periods. We thus investigate the data excluding all war-related episodes. We find that wardoes seem to play a role in generating depression. Of the 21 depression episodes without deflation,10 were related to a world war: 4 during WWI, 3 during WWII, and 3 right after WWII. (Weview Japan’s dismal growth in 1949—54 as war-related.) But that does not change our result aboutdeflation and depression. Based on all of the data outside of the Great Depression, a regressionof output growth on inflation has a slope coeﬃcient of .04 (.03). Excluding all the data fromthe war-related episodes (1914—19, 1939—44, 1944—49) and the 1949—54 episode for Japan gives aslope coeﬃcient of .10 (.03). These data thus show little or no relationship between deflation and4depression. This finding is consistent with that of Michael Bordo, John Landon-Lane, and AngelaRedish (2002).C. The Overall RelationIn Figure 3, we display all of the data. Here the regression line has a slope coeﬃcient of .08 (.03).Thus, a one percentage point drop in inflation is associated with a drop in the average real growthrate of just .08 of a percentage point, say, from 3.08 to 3.00 percent.The relation between deflation and depression does diﬀer pre- and post-WWII. The slopecoeﬃcients are .11 (.04) in the pre-WWII data and −.03 (.04) in the post-WWII data. The postwarresult is consistent with the results of many studies, which typically associate higher inflation andlower growth.D. JapanIn the postwar data, Japan’s experience in the 1990s is the closest that any major economy hascome to having both a deflation and a depression. Economists debate whether this experience isevidence of a link between these conditions. To put Japan’s recent experience in context, considerFigure 4, where we plot its annual rates of output growth and inflation as well as their five-yearaverages since 1960.Figure 4 essentially shows a 40-year decline in the output growth rate (4A) and a 30-year decline in the inflation rate (4B). We think standard theories–either neoclassical or newKeynesian–would have a hard time blaming Japan’s secular growth slowdown on its secular declinein inflation. But that slowdown would naturally arise in many growth models in which a countrygrew rapidly in the early postwar period because it had been below its steady-state growth path; asit caught up to this path, its growth would naturally slow.Has Japan’s growth slowed too much? Not relative to countries like Italy and France. At1.41, Japan’s growth in the 1990s was dismal compared to the U.S growth of 3.20, but not compared5to the growth of Italy (1.61) or France (1.84).III. Concluding RemarksThe data suggest that deflation is not closely related to depression. A broad historical look findsmany more periods of deflation with reasonable growth than with depression and many more periodsof depression with inflation than with deflation. Overall, the data show virtually no link betweendeflation and depression.This study simply characterizes the relation in the raw data between deflation and outputgrowth, with no attempt to control for anything, like the type of monetary regime or the extentto which the deflation was anticipated. Perhaps a link between deflation and depression could beteased out of the data with a well-motivated set of controls. Our contribution here is to note thatwithout such controls, the data show no obvious relationship. The bar has thus been raised forthose who claim that deflation and depression are closely linked.6REFERENCESBackus, David K. and Kehoe, Patrick J. “International Evidence on the HistoricalProperties of Business Cycles.” American Economic Review, September 1992, 82(4), pp. 864—88.Bernanke, Ben S. and Carey, Kevin. “Nominal Wage Stickiness and Aggregate Supplyin the Great Depression.” Quarterly Journal of Economics, August 1996, 111(3), pp. 853—83.Bordo, Michael D. and Kydland, Finn E. “The Gold Standard as a Rule: An Essay inExploration.” Explorations in Economic History, October 1995, 32(4) pp. 423—64.Bordo, Michael D.; Landon-Lane, John and Redish, Angela. “Good versus BadDeflation: Lessons from the Gold Standard Era.” Manuscript, Rutgers University, 2002.Chari, V. V.; Christiano, Lawrence J. and Kehoe, Patrick J. “Optimality of theFriedman Rule in Economies With Distorting Taxes.” Journal of Monetary Economics, April 1996,37(2) pp. 203—23.Cole, Harold L. and Kocherlakota, Narayana. “Zero Nominal Interest Rates: WhyThey’re Good and How to Get Them.” Federal Reserve Bank of Minneapolis Quarterly Review,Spring 1998, 22(2), pp. 2—10.Cole, Harold L. and Ohanian, Lee E. “Re-Examining the Contributions of Money andBanking Shocks to the U.S. Great Depression,” in Ben S. Bernanke and Kenneth Rogoﬀ, eds., NBERmacroeconomics annual 2000. Cambridge, Mass.: MIT Press, 2001, pp. 183—227.Cole, Harold L.; Ohanian, Lee E. and Leung, Ron. “Deflation, Real Wages, and theInternational Great Depression: A Productivity Puzzle.” Manuscript, UCLA, 2003.Eichengreen, Barry and Sachs, Jeﬀrey. “Exchange Rates and Economic Recovery inthe 1930s.” Journal of Economic History, December 1985, 45(4), pp. 925—46.Friedman, Milton. “The Optimum Quantity of Money,” in The optimum quantity ofmoney and other essays. Chicago: Aldine, 1969, pp. 1—50.Rolnick, Arthur J. and Weber, Warren E. “Money, Inflation, and Output under Fiatand Commodity Standards.” Journal of Political Economy, December 1997, 105(6), pp. 1308—21.7Table 1  Deflation and Depression: Where’s the Link? Regression of Average Growth on Average Inflation   Regression Equation Episode Constant Slope Great Depression Episode (1929–34) 1.15  (1.24) .40  (.28)    Other Episodes (Excluding Great Depression)    • Including World War 3.02 (.19) .04 (.03)     • Excluding World War 2.96 (.15) .10 (.03)     • Before Great Depression      (Pre-1939) 2.35 (.18) .11 (.04)     • After World War II      (Post-1949) 4.00 (.28) −.03 (.04)    All Episodes (1820–2000) 2.74 (.17) .08 (.03)  Frame 002  09 JanInflation (%)Growth(%)-10 -8 -6 -4 -2 0 2-8-6-4-2024Figure 1. The Great Depression EpisodePortugalJapanNorwayDenmarkUKAustraliaSwedenSpainGermany BrazilItaly FranceNetherlands ArgentinaCanadaUSA= 1.15 + .40 π(1.24) (.28)Annual Inflation and Real Output Growthin 16 Countries in 1929-34gyInflation (%)Growth(%)-10 -8 -6 -4 -2 0 2-8-6-4-2024The Great Depression EpisodeAverage Inflation and Real Output Growth in 16 Countries inFigure 1PortugalJapanNorway DenmarkUKAustraliaSwedenSpainGermanyBrazilItaly FranceNetherlands ArgentinaCanadaUSgy=1.15 + .4π(1.24) (.28)Inflation (%)Growth(%)-15 -10 -5 0 5 10 15 20-15-10-505101520Figure 2. Episodes Outside of the Great DepressionNetherlands (1945-49)Including war:= 3.02 + .0πExcluding war:π(.19) (.03)= 2.96 + .10(.15) (.03) Netherlands (1939-44)USA (1939-44)Average Inflation and Real Output Growthin 17 Countries in All 5-year Periods Except 1929-34gygyxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx xxxxInflation (%)Growth(%)-15 -10 -5 0 5 10 15 20-8-40481216Pre-1939Post-1949OthersxFigure 3. All EpisodesPre-1939:= 2.35 + .11π(.18) (.04)Overall:= 2.74 + .08 π(.17) (.03)Post-1949:= 4.00 - .03 π(.28) (.04)Average Inflation and Real Output Growthin 17 Countries in All 5-year Periods, 1820-2000gygygy1960 1965 1970 1975 1980 1985 1990 1995-50510152025Figure 4B Inflation%1960 1965 1970 1975 1980 1985 1990 1995-10-5051015Figure 4A Real Output Growth%Figure 4. Japan Since 1960Annual RateReal Output Growth and Inflation in Japan in 1960-995-year Average Rate·

Deflation and depression: Is there an empirical link?

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Deflation and depression: Is there an empirical link?

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