PDF Ebook Three Great American Disinflations
Since at least the time of David Hume (1752) in the mid-18th century, it has been recognized that episodes of deflation or disinflation may have costly implications for the real economy, and much attention has been devoted to assessing how policy should be conducted to reduce such costs. The interest of prominent classical economists in these questions, including Hume, Thornton, and Ricardo, was spurred by practical policy debates about how to return to the gold standard following episodes of pronounced wartime inflation. Drawing on limited empirical evidence, these authors tried to identify factors that contributed to the real cost of deflation, including those factors controlled by policy. They advocated that a deflation should be implemented gradually, if at all; in a similar vein a century later, Keynes (1923) and Irving Fisher (1920) discussed the dangers of trying to quickly reverse the large runup in prices that occurred during World War I and its aftermath.
While the modern literature has provided substantial empirical evidence to support the case that deflations or disinflations are often quite costly, there is less agreement about the underlying factors that may have contributed to high real costs in some episodes, or that might explain pronounced differences in costs across episodes. Indeed, disagreement about the factors principally responsible for influencing the costs of disinflation helped fuel contentious debates about the appropriate way to reduce inflation during the 1970s and early 1980s. Many policymakers and academics recommended a policy of gradualism–reflecting the view that the costs of disinflation were largely due to structural persistence in wage and price setting–while others recommended aggressive monetary tightening on the grounds that the credibility of monetary policy in the 1970s had sunk too low for gradualism to be a viable approach.
In this paper, we examine three notable episodes of deliberate monetary contraction: the post-Civil War deflation, the post-WWI deflation, and the Volcker disinflation. One goal of our paper is to use these episodes to illuminate the factors that influence the costs of monetary contractions These episodes provide a fascinating laboratory for this analysis, insofar as they exhibit sharp differences in the policy actions undertaken, in the credibility and transparency of the policies, and in the ultimate effects on inflation and output. Our second objective is to evaluate the ability of a variant of the New Keynesian model that has performed well in fitting certain features of post-war U.S. data to account for these historical episodes.
Our paper begins by providing a historical overview of each of these episodes. In the decade following the Public Credit Act of 1869, which set a 10 year timetable for returning to the Gold standard, the price level declined gradually by 30 percent, while real output grew at a robust 4-5 percent per year. We argue that the highly transparent policy objective, the credible nature of the authorities’ commitment, and gradual implementation of the policy helped minimize disruptive effects on the real economy. By contrast, while prices fell by a similar magnitude during the deflation that began in 1920, the price decline was very rapid, and accompanied by a sharp fall in real activity. We interpret the large output contraction as attributable to the Federal Reserve’s abrupt departure from the expansionary policies that had prevailed until that time; fortunately, because the ultimate policy objective was clear (reducing prices enough to raise gold reserves), the downturn was fairly short-lived. Finally, the Volcker disinflation succeeded in reducing inflation from double digit rates in the late 1970s to a steady 4 percent by 1983, though at the cost of a severe and prolonged recession. We argue that the substantial costs of this episode on the real economy reflected the interplay both of nominal rigidities, and the lack of policy credibility following the unstable monetary environment of the previous 15 years.
We next attempt to measure policy predictability during each of the three episodes in order to quantify the extent to which each deflation was anticipated by economic agents. For the two earlier periods, we construct a proxy for price level forecast errors by using commodity futures data and realized spot prices. While these commodity price forecast errors provide very imperfect measures of errors in forecasting the general price level, we believe that they provide useful characterizations of the level of policy uncertainty during each period: in particular, the commodity price forecast errors in the early 1920s were much larger and more persistent than in the 1870s. This pattern confirms other evidence on policy predictability during each episode taken from bond yields, contemporary narrative accounts, and informal surveys. Finally, for the Volcker period, we utilize direct measures of survey expectations on inflation to construct inflation forecast errors, and show that forecast errors were large and extremely persistent, suggesting a high degree of uncertainty about the Federal Reserve’s policy objectives.
We then examine whether a relatively standard DGSE model is capable of accounting for these different episodes. The model that we employ is a slightly simplified version of the models used by Christiano, Eichenbaum, and Evans (2005) and Smets and Wouters (2003). Thus, our model incorporates staggered nominal wage and price contracts with random duration, as in Calvo (1983) and Yun (1996), and incorporates various real rigidities including investment adjustment costs and habit persistence in consumption. The structure of the model is identical across periods, aside from the characterization of monetary policy. In particular, we assume that the monetary authority targets the price level in the two earlier episodes, consistent with the authorities desire to reinstate or support the Gold standard; by contrast, we assume that the Federal Reserve followed a Taylor style interest rate reaction function in the Volcker period, responding to the difference between inflation and its target value. Moreover, we assume that agents had imperfect information about the Federal Reserve’s inflation target during the Volcker episode, and had to infer the underlying target through solving a signal extraction problem.
We find that our simple model performs remarkably well in accounting for each of the three episodes. Notably, the model is able to track the sharp but transient decline in output during the 1920s, as well as generate a substantial recession in response to the monetary tightening under Volcker. More generally, we interpret the overall success of our model in fitting these disparate episodes as reflecting favorably on the ability of the New Keynesian model – augmented with some of the dynamic complications suggested in the recent literature – to fit important business cycle facts. However, one important twist is our emphasis on the role of incomplete information in accounting for the range of outcomes.
Finally, we use counterfactual simulations of our model to evaluate the consequences of alternative strategies for implementing a new nominal target (i.e., either a lower price level, or a lower inflation rate). We find that under a highly transparent policy regime, a new nominal target can be achieved with minimal fallout on the real economy, provided the implementation occurs over a period of at least 3-4 years. In this vein, we use model simulations to show that a more predictable policy of gradual deflation – as occurred in the 1870s – could have helped avoid the sharp post-WWI downturn. However, our analysis of the Volcker period emphasizes that the strong argument for gradualism under a transparent and credible monetary regime becomes less persuasive if the monetary regime lacks credibility. In this lower credibility case, an aggressive policy stance can play an important signalling role insofar as it makes a policy shift – such as a reduction in the inflation target – more apparent to private agents. Because inflation expectations adjust more rapidly than under a gradualist policy stance, output can rebound more quickly.
The rest of the paper proceeds as follows. Section 2 describes the three episodes, while Section 3 examines empirical evidence on the evolution of expectations during each episode. Section 4 outlines the model, and Section 5 describes the calibration. Section 6 matches the model to the salient feat.
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