Front Matter

Front Matter

Taimur Baig, Jörg Decressin, Tarhan Feyzioglu, Manmohan Kumar, and Chris Faulkner-MacDonagh
Published Date:
June 2003
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© 2003 International Monetary Fund

Production: IMF Multimedia Services Division

Typesetting: Choon Lee

Figures: Theodore F. Peters, Jr.

Cataloging-in-Publication Data

Deflation : determinants, risks, and policy options / Manmohan S. Kumar [et al.] — Washington, D.C. : International Monetary Fund, 2003.

p. cm.—(Occasional paper ; 221)

Includes bibliographical references.

ISBN 1-58906-227-2

1. Deflation (Finance). 2. Economic policy. I. Kumar, Manmohan S. II. International Monetary Fund. III. Occasional paper (International Monetary Fund); no. 221

HC229.D34 2003

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The following symbols have been used throughout this paper:

  • … to indicate that data are not available;
  • — to indicate that the figure is zero or less than half the final digit shown, or that the item does not exist;
  • – between years or months (e.g., 2000–01 or January–June) to indicate the years or months covered, including the beginning and ending years or months;
  • / between years (e.g., 2000/01) to indicate a fiscal (financial) year.

“Billion” means a thousand million.

Minor discrepancies between constituent figures and totals are due to rounding.

The term “country,” as used in this paper, does not in all cases refer to a territorial entity that is a state as understood by international law and practice; the term also covers some territorial entities that are not states, but for which statistical data are maintained and provided internationally on a separate and independent basis.


After several decades of worrying about inflation—a rising general price level—there is today growing concern about deflation—a falling general price level. In part, central banks and monetary authorities are victims of their own success: the global trend of the past 15 years toward having more independent and anti-inflation oriented central banks has contributed to the sharp and widespread stemming of price increases, with inflation rates and long-term interest rates reaching half-century lows in many countries. The slower the pace at which prices are rising, the less of a shock it takes to push the economy into territory where prices, on average, start falling. A large enough negative demand shock can do the trick, and with the global economy yet to fully emerge from the widespread slowdown that began in 2001, it is important to ask just how vulnerable the world is now to deflation. Even if the probability of global deflation is low (in the report, we argue it is fairly low if not necessarily minimal), this does not mean there is no risk of having deflation in major regions.

One does not want to overstate the effects of falling prices per se; in many cases price declines are initially no more than a lagging indicator of low general economic activity. The danger, though, is that once set in motion, price declines may destabilize the economy through the financial system, through labor market frictions, and through declining collateral values. Certainly, the last period of widespread deflation, the Great Worldwide Depression of the 1930s, was calamitous. In the United States, for example, unemployment rose to 25 percent as prices fell by about the same amount. Japan has not fared nearly so badly during its five years of declining prices, but at the same time nor has it emerged from its decade long downturn. Perhaps these are exceptional cases, but they also have to serve as warning posts to economies teetering on deflation. At the very least, the concurrent trends of low inflation and rising output gaps we see in many countries means that deflation should be on the radar screen.

We have been trying to focus attention on deflation risks for some time in our World Economic Outlook presentations. In view of our growing concern about the slow pace of global economic activity, last November I set up a task force, headed by Manmohan Kumar of the IMF Research Department and including Taimur Baig, Jörg Decressin, Chris Faulkner-MacDonagh, and Tarhan Feyzioğlu from three area departments, to investigate the problem under my general supervision. This Occasional Paper is the report of that task force. It’s a broad-ranging study, which deals with a number of thorny analytical questions, provides an assessment of historical experiences, and develops a framework for assessing risks as well as policy options. Since our study was issued on the Internet in mid-May, it has contributed to the lively debate about the causes and consequences of deflation and the risks in a variety of countries. Though some have challenged our assessments as too alarmist, others have welcomed our candor in highlighting risks, especially given that policymakers in many countries still have time to act to mitigate the risk. It is the nature of surveillance work that sometimes the dog does bark, and let’s hope that deflation does not rear its head too widely over the coming year. But if it does, perhaps the broad policy recommendations in this report will be of some use. Our bottom line is that there is a good case for acting pre-emptively to stay clear of deflation and, if deflation sets in anyway, to be prepared to take unorthodox policy measures in conjunction with a clear communication strategy stating that the central bank is both able and determined to restore positive inflation within a reasonably narrow time frame.

The paper emphasizes that deflation can arise from both supply-driven and demand-driven shocks. But regardless of the source, our view is that deflation is seldom benign. Even with a positive supply shock, reflecting productivity improvements, for instance, a generalized decline in prices can be problematic if nominal wages are rigid downwards, so that sectors not experiencing productivity improvements fail to flexibly adapt. Deflation also leads to a redistribution of income from debtors to creditors—typically depressing demand. Credit intermediation can be severely distorted as collateral loses value. Given the zero floor on nominal interest rates, monetary policy becomes more difficult, though this problem is more likely to arise when deflation is caused by an adverse demand shock.

An assessment of the historical experiences emphasizes that deflation can be costly and remarkably difficult to anticipate. It is true that deflation was relatively common in the nineteenth century (basically when gold discoveries failed to keep up with global growth under the gold standard). But it is also true that deflation was hard to anticipate (in part because the timing of major gold discoveries was hard to predict), deflation caused a great deal of trauma to borrowers, and growth might well have been higher without it. In the late 1920s and early 1930s, U.S. policymakers exacerbated deflation by underestimating its consequences and by failing to take aggressive action. In contrast, countries that exited the gold standard earlier—such as Sweden and Japan—recovered from deflation relatively quickly.

One aspect of this study that is particularly noticeable is its multi-country perspective. It is the first to present an analytical framework for assessing countries’ risk of deflation. The framework takes into account a variety of indicators like output gaps and changes in equity markets and tries to aggregate them in a country-specific way to arrive at a measure of deflation risk. A second approach uses estimated Phillips Curve relationships for the G-7 economies to obtain a likelihood of deflation setting in. These two very different approaches turn out to provide remarkably similar answers, supporting our view that our deflation risk assessments are fairly balanced and reasonable ones.

Among the more striking results of our study is the conclusion that there is a risk that deflation in Japan—now hovering around 1 percent—may become worse. The United States is in the low risk category, reflecting an expected narrowing in the output gap, relief provided by the recent depreciation of the U.S. dollar, resilience in the financial sector, and the explicit willingness of policymakers to take preemptory action. The euro area as a whole is also at low risk, although there is considerable risk of mild deflation in Germany while risk of pernicious sustained deflation is low. China, although experiencing deflationary pressures, fits into the low-risk category going forward, thanks to the country’s famously high growth rates. But there are vulnerabilities given excess capacity in China’s state-owned enterprises and large pool of excess labor.

The report not only quantifies countries’ risks of deflation, it also discusses policies they can adopt to try to steer clear of the problem. Monetary policy should take the lead, and with flexible monetary policy regimes, clear communication with the markets is important, as is a willingness to act quickly. Policymakers should not set an inflation target (whether or not announced) that is too low, but instead provide a “buffer zone” to obtain insurance. This is especially important in large and heterogenous monetary unions, and in monetary unions where product and labor markets and services are not yet as integrated as within countries. Fiscal policy can play an important role in supporting incomes, and relieving pressure on firms’ and households’ balance sheets. In an environment of deflationary expectations taking hold, measures to boost return on capital investment provide efficiency gains while signaling authorities’ commitment to prevent a generalized decline in prices and have an added attraction (see Rogoff, 1998).

Policymakers face a difficult challenge under deflation, because the traditional relationships between policy instruments and economic variables may be impaired or altered. Some have argued that liquidity traps are deeply problematic, and lead to policy impotence. I would argue that monetary policy can still be effective in a liquidity trap. A good analogy is with a sand trap when playing golf: when in the trap, if you hit the ball hard, and with skill, and in the right direction, you can get it back toward the green, albeit there is some risk of overshooting. But if you don’t hit the ball firmly, you remain stuck in the sand. The central banks’ communication strategy is also quite important, and the paper emphasizes that (see Rogoff, 2002). Structural reforms can play an important role in combating deflation by increasing flexibility in factor markets. But they should not be regarded as a prerequisite for the monetary and fiscal response.

Kenneth Rogoff

Economic Counselor and Director, Research Department


This paper presents the findings of an interdepartmental task force of IMF staff set up to examine the issue of deflation. It does not necessarily reflect the views of national authorities or IMF Executive Directors.

The paper was prepared under the general direction of Kenneth Rogoff, Economic Counselor and Director of the Research Department, who also established the task force in conjunction with David Burton, Director of the IMF’s Asia and Pacific Department, Michael Deppler, Director of the European I Department, and Anoop Singh, Director of the Western Hemisphere Department. The task force was headed by Manmohan S. Kumar and comprised Taimur Baig, Jörg Decressin, Chris Faulkner-MacDonagh, and Tarhan Feyzioğlu. The report was reviewed by the above departments, as well as by other departments of the IMF, discussed at an informal Executive Board seminar on May 14, and published on the IMF’s website,, on May 18.

The authors are grateful to the department Directors for support and advice. They also valued comments and suggestions on earlier drafts of the report from many colleagues, in particular David Robinson and Carmen Reinhart, as well as Tamim Bayoumi, Biagio Bossone, Peter Clark, Steven Dunaway, Leslie Lipschitz, George Mackenzie, and V. Sundararajan. They appreciated the discussions they had with Michael Bordo, Bankim Chadha, Robert Corker, Gauti Eggertsson, Robert Ford, Joseph Gagnon, Graham Hacche, Benjamin Hunt, Aasim Husain, Mads Kieler, Laura Kodres, Douglas Laxton, Saul Lizondo, Maitland MacFarlan, Jonathan Ostry, Eswar Prasad, Avinash Persaud, Vincent Reinhart, Arvind Subramanian, Thomas Rumbaugh, Christopher Towe, and several other colleagues. Eric Bang, Ken Kashiwase, and Sarma Jayanthi provided excellent research assistance. Finally, the authors are grateful to Patricia Medina and Dawn Heaney for their able assistance in the preparation of this manuscript and to Jeff Hayden of the External Relations Department, who provided expert editing and oversaw the speedy production of this report.

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