Can a zero lower bound on price movements generate positive inflation during a recession?

by on September 11, 2013 at 6:33 am in Economics | Permalink

From the comments, Ano writes:

I think an additional factor contributing to the “why is there 1.6% inflation” question is the following: The “right” wage offer for each individual worker varies from worker to worker. The distribution of wage offers gets trimmed at zero. So even a distribution that would have a mean below zero in a non-rigidity world can have a positive mean if the distribution gets trimmed at zero. It’s another zero lower bound at work in the labor market!

There is a related Paul Krugman blog post here.

I have several worries about this approach, but my biggest one is this.  Even with truncation, where are so many inflationary pressures coming from in the first place?  Let’s say for instance (to make it easy) that half of the economy is subject to (stifled and truncated to zero) deflationary pressures, and the other half is subject to (non-stifled) inflationary pressures of 3.2%.  To make this easy to talk about, imagine those halves average out to 1.6% inflation.

What does it say about your economy — vis-a-vis the all-important business cycle fact of comovement — if half of the sectors are seeing inflationary pressure at 3.2%?

One option is that those sectors are the victim of negative supply shocks.  I am comfortable with a comparable conclusion, namely that both AD and AS shocks have been important in a variety of recent economic downturns, although I would not use this chain of reasoning to get there.

Another option is that these non-stifled sectors have seen big boosts in demand and thus their prices are rising.  Again, that violates the strong empirical regularity of business cycle comovement.  In a traditional deflationary downturn, virtually all sectors are negatively affected, with a few notable exceptions.  What kind of business cycle would this be, if half the economy is seeing a positive 3.2% worth of demand-side pressures?

Of course the number 3.2%, the division of the economy into halves, and the like are artifacts, to make this easy to discuss on a blog.  But to the extent you make the non-stifled sector of the economy smaller, the shocks hitting it have to be larger, and so on, so that is no easy way out of the basic dilemma.

Here is a detailed look at why eurozone inflation rates are not lower than they are.  Here is a brief look at United Kingdom inflation rates:

1. CPI annual inflation stands at 2.9% in June.

2. Core inflation stands at 2.3% and has not been below 2% in some time.

3. The producer price index is showing 4.2% inflation (see the first link).

Is that being driven by the zero point truncation of nominal wages?  I don’t think so.  By the way, that is about as a clear of a refutation of liquidity trap models as one could expect to find.

Addendum: Arnold Kling offers comment.

1 Simon K September 11, 2013 at 9:11 am

Unless I’m misunderstanding (entirely possible – IANAE) a zero lower bound of wages implies that (the average of) wages can never fall. Is that a reasonable assumption? There’s at least a three ways I can think of instantly that that could be wrong.

1) All the same workers could keep their jobs, but their salaries could be cut.
2) High paid workers could be laid off and replaced by lower paid (e.g. younger, less skilled) ones
3) High paid workers could be laid off and not replaced, reducing both the number of jobs and the average wages

At different times, in different sectors (but especially in the public sector) we’ve seen some of all three of those in the UK over the last couple of years.

2 Alex Godofsky September 11, 2013 at 9:52 am

Another option is that these non-stifled sectors have seen big boosts in demand and thus their prices are rising. Again, that violates the strong empirical regularity of business cycle comovement. In a traditional deflationary downturn, virtually all sectors are negatively affected, with a few notable exceptions. – See more at:

A sector can be negatively affected and still see positive inflationary pressure. cf. programmers

3 Joseph Ward September 11, 2013 at 10:26 am

Doesn’t this get into the “Eurozone as a poorly sized currency area” because in some areas of the Eurozone you have pretty significant inflation and others where there is significant deflation?

Thus when you’re collecting statistics for the entire Eurozone, the size of the economies that are generating inflation mute the ones that are experiencing deflation, but it doesn’t change the fact that those countries are enduring hellish conditions.

4 Alex A. September 11, 2013 at 11:27 am

It’s a puzzle, but if we look at the actual Great Depression, inflation proceeded after the initial financial shock despite massive unemployment. CPI inflation spiked to 5% y-o-y in 1934 with unemployment still over 15%!!

A recovery can still somehow generate inflation even when there’s an enormous, undisputable output gap. If it’s a puzzle right now, it’s been a puzzle for 80 years.

5 Bob Knaus September 11, 2013 at 11:33 am

My grandfather was an apple grower. He used to say “There may be a surplus of apples, but there’s always a shortage of good apples.”

Not that a “bad apple” theory is likely to be any more popular than ZMP 🙂

6 Matthew September 11, 2013 at 11:39 am

You could just as easily point to the failure of massively expansionary monetary policy to generate even slightly above-average inflation as about as good a vindication of liquidity trap models as one could expect to find.

More to the point, I think what you should have said is that the presence of moderate inflation is a challenge to calvo pricing, not liquidity trap models. There is nothing inherent to the idea of a liquidity trap that requires deflation: if the “natural rate of interest” is negative enough, then we can be constrained by the zero-lower-bound even while experiencing inflation. The only part of the New Keynesian liquidity trap model that breaks down is the calvo pricing, which requires a deflationary shock in order to get movement down the (non-vertical) short-run supply curve. This shortcoming is easily fixed if we replace calvo pricing with, say, sticky rates of change in prices–that is, companies have committed in advance to future price changes, and it takes time (or money) to update those plans. Most New Keynesians view Calvo pricing as an analytical shortcut, not a literal truth. The reality is intractably complex to model, but qualitatively similar to Calvo pricing. They tend to be willing to view the persistence of low, stable inflation in the face of massive monetary expansion as evidence for, not against, the liquidity trap theory.

In your particular example, bear in mind that many employment contracts (often negotiated by unions, which are more common in UK than US) have specified nominal annual pay raises that were agreed to on the basis of expected inflation and productivity growth. Thus, even in the face of a deflationary shock, these wages will continue to rise until the contract expires. There are many models showing that these labor contracts are a sufficient source of rigidity to get the New Keynesian liquidity trap results.

7 Noah Yetter September 11, 2013 at 11:47 am

Since when is comovement a “fact”? Next thing you’re going to tell me neutrality of money is a fact.

Sectors grow and shrink unevenly, THAT’S a fact. The idea that some sectors are seeing deflation and others inflation isn’t crazy at all. Indeed nothing else is possible. If you look out into the world and see the same rate of inflation (or deflation) in every sector then your measurement method is broken.

8 Matt Young September 11, 2013 at 1:56 pm

I am looking at producer price index. Stuck at zero for three years. Yet cpi keeps rising. Producers seem to balk at paying more for some inputs that does not bother the consumer so much. Tell me why, my own explanation is incomplete.

9 Merijn Knibbe September 11, 2013 at 5:07 pm

It’s just not right to look at consumer prices only in such situations. When we look at ‘domestic demand’ inflation (including prices of investment goods and government purchases) inflation in the UK is (second quarter 2013, YoY) 1,3%, quite a bit lower than consumer price inflation an core inflation. And the same for the Eurozone: domestic demand inflation has been considerably lower than consumer price inflation since 2008, which adds up after about five years. And let’s not forget that house prices in countries like Ireland, Spain, the UK and the Netherlands (overthere including the cut in the sales tax from 6 to 2%) are down with 30 to 50%. The housing market is of course somewhat isolated from the GDP-goods and services market as it’s not mainly financed by income but by lending – but in my world a 50% decline counts as ‘serious’. So, look at the right metrics. Remember, by the way, that NGDP analysis as well as (flawed) ideas about macro Real Unit Labour Costs do not use consumer price inflatin but the GDP deflator. The GDP deflator is however somewhat complicated, as a decrease of prices of imported stuff will show as an increase of nominal value added and, as the deflator is calculated by dividing nominal GDP by a volume index of goods and services, an INCREASE of the GDP deflator.

10 lxdr1f7 September 11, 2013 at 11:50 pm

Could the large stock of private debt be contributing to sticky prices?

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