The Deflation Bias and Committing to Being Irresponsible

Abstract

I model deflation, at zero nominal interest rate, in a microfounded general equilibrium model. I show that one can analyze deflation as a credibility problem if three conditions are satisfied. First: The government's only policy instrument is increasing the money supply by open market operations in short-term bonds. Second: The economy is subject to large negative demand shocks. Third: The government cannot commit to future policy. I call the credibility problem that arises under these conditions the deflation bias. I propose several policies to solve it. They all involve printing money or issuing nominal debt. In addition they require cutting taxes, buying real assets such as stocks, or purchasing foreign exchange. The government "credibly commits to being irresponsible" by pursuing these policies. It commits to higher money supply in the future so that the private sector expects inflation instead of deflation. This is optimal since it curbs deflation and increases output by lowering the real rate of return.

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