Reply to PK: Financial frictions pushed against deflation

Here Paul Krugman muses on how well standard macro models did at predicting the after-effects of the crisis.  He highlights how the prediction that the expansion of central bank balance sheets would NOT lead to runaway inflation was encoded in those standard models [it’s the zero bound, stupid], contrary to the permahawks’ scare-mongering.

But he asks why there wasn’t deflation given the large contraction in output.

A few answers.

First, it’s not over yet, at least not in the UK, where headline inflation [which overstates true by maybe 0.5pp/year] has been around since February 2015].  So there’s still hope that further deflationary catastrophe might rescue this prediction of the models.

Second, models of financial frictions bolted onto standard DSGE models show how contractions in credit can throttle supply, putting upward pressure on inflation.  These frictions have eased now in the UK and the US, with spreads falling back to more normal levels.  But initially they could have been part of the story of bouyant inflation.

A third explanation that can take up the slack now that financial intermediation is working more normally is ‘hysteresis’.  The tendency for large demand-sized contractions in output to impair potential output, perhaps through the eroding of the skills and labour force attachment of the unemployed, or the deterioration and scrapping of the capital stock.


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One Response to Reply to PK: Financial frictions pushed against deflation

  1. Nanikore says:

    Warnings were made in the very beginning about the effects of austerity policies on ‘potential output’ or more correctly speaking, productive capacity, and what sort of recovery would eventually occur if there was a shrinkage in the productive base. Are these ‘hysteresis’ effects (interesting to see this term used again) in ‘your model’.

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