Trainees practicing inflation and deflation of hospital tent structures, GlobalMedic Training Day, Toronto, June 2011. Photo: Wikimedia Commons

While the European Central Bank, governments and many economists complain about the danger of deflation a currently published microeconomic analysis from the famous Kiel Institute for the World Economy tells a different story. The paper explores the validity of the argument that deflation should reduce aggregate demand because consumers defer their purchases at the level of individual goods.

The paper uses the assumption that the believed consumption reducing deflation effects on a macroeconomic level should also be observed on a microeconomic level. The authors use a disaggregated dataset of the federal statistical office about the price development in Germany. It is empirically interesting that periods of inflation have been the exception during the time of currencies backed by precious metals while deflation periods have been the rule. The introduction of fiat money changed this relation.

While there have been actually sinking prices over more than five years for some consumer goods, especially some groceries, this did not necessarily result in sinking consumption of these goods. In 74 cases a price reduction led to a fall in the amount of consumption, but in 116 cases the price reduction led to rising consumption of these goods. The data does not wholly disprove the Tobin assumption but rather expresses doubt about its universal validity.

Finally, the paper could not totally defeat the ghost of deflation. However the general assumption that falling prices lead to a postponement of consumption is questionable. If there is no evidence for the consumption reducing effects of falling prices on the microeconomic level, why there should be a difference on the macroeconomic level? Central banks should restrain from overestimating deflation.

For more detailed information: Klodt/Hartmann, Deflation und Konsumstau: Mikroökomische Evidenz, (Kiel Working Papers no. 1935, July 2014). http://www.ifw-members.ifw-kiel.de/publications/deflation-und-konsumstau-mikrookonomische-evidenz/KAP_1935_Deflation.pdf