How will the price-specie flow mechanism operate in Cyprus?

If you imagine Cyprus as a closed system, the levy is deflationary.  Prices will fall, and for the purposes of argument, let’s say they fall ten percent (just a number).

That deflation likely will crush the economy, but many individuals will find the real value of their bank balance intact, at least when it comes to spending in the home market.  In this regard much of the incidence of the levy is quite indirect.  The most obvious effect is that purchasing power command over imports falls immediately.

From the first-order static effects alone, it is not clear that the chosen program hurts the poor more than would exchange rate depreciation under a floating rate system.  That too lowers the command of bank balances over imports.

To the extent Cypriot bank deposits are proportional to wealth (a debatable proposition, and at sufficiently high levels of wealth the surplus may all go abroad), the initial levy is actually progressive in its impact, at least relative to taxes on income.  Wealth inequality is usually much more pronounced than is income inequality, so a linear tax on a proxy for wealth will be more progressive, perhaps considerably more progressive.

Many of the most regressive effects will come from the second-order economic devastation, unemployment, and so on.

Of course Cyprus is not a closed system.  Still, I would think in the short run and probably in the medium run too, foreign money and foreign labor and tourists are now somewhat afraid to enter Cyprus, thus there will be a persistence of the deflation.  The deflation should be strongest on the side of the non-tradeables.  Exporters are likely to do better than workers in the service sectors.  The ongoing negative income effects, from the secondary consequences of the levy, will muddy predictions.

Since the levy has been a surprise, I do not see a “Ricardian” argument that the value of the bailout offsets the deflationary pressures.  The bailout had been expected anyway, plus much of its value is reaped by parties other than Cypriot consumers.  Nonetheless the “transfer” is running in two directions here, and not just one.

There are many tricks and traps in the analysis, and numerous other angles to consider.  These issues were debated a good deal in the 1920s (see Jacob Viner, the section on the transfer problem), and also by Mill and Torrens in the 19th century.