May 18, 2016
The NYT is once again confused about the story of deflation, telling readers that it’s bad news for Japan that the yen has recently risen in value since a higher yen reduces import prices, increasing the risk of deflation. While a higher valued yen is a problem because it makes Japan’s goods and services less competitive internationally, and therefore worsens the trade deficit, its impact on the inflation rate is of little consequence for the economy.
The impact on the trade balance is straightforward and direct. The higher valued yen will make Japanese made goods and services more expensive to people in other countries, so they will buy less of them. On the other hand, imports will be cheaper for people living in Japan, so they will buy more imports. The net effect is to worsen the trade balance, decreasing demand in the economy.
However, the effect of lower import prices on the inflation rate is likely to have little effect on demand. While it is often claimed that deflation hurts demand because it leads consumers to delay purchases with the idea that the price will be lower due to waiting, as a practical matter, this makes almost no sense.
If the deflation rate is -1.0 percent (much larger than Japan has seen in recent years), it means that consumers can save themselves 1.0 percent of the price of a product by delaying a purchase for a year. On a $20,000 car, a consumer can save $200 if they wait a year. On a $500 television set, they will save $5.00 and on a $30 shirt, they will save 30 cents. If the deflation rate is half this much (-0.5 percent), the savings will be half of these sums. It is unlikely that many people will put off purchases for such savings.
The more likely impact will be on investment. The issue here is the real interest rate, the difference between the rate of interest firms must pay and the rate of increase in the price of the products they are selling.
Suppose that a company was selling a product for $1000 (or the yen equivalent price), with $100 of the cost of the production of this product due to imported items. Suppose that its costs of production were $800, leaving a profit of $200 on each item. Now imagine that a 10 percent rise in the yen leads the price of the imported inputs to fall to $90. If the drop in the price of imported inputs is fully passed on to consumers, then the price of the product falls to $990, leaving profit margins unchanged.
In this case, the company has the same incentive to invest after the rise in the value of the yen as it did before the rise in the value of the yen. The one-time drop in prices is not a problem. (If the drop in the price of imported inputs is not fully passed on, then the increased profit margin would increase the incentive to invest.) This would only be an issue if it was expected that the yen would keep rising leading to continuing falls in the price of the product. For this reason, a reduction in the inflation rate, or even deflation, that is the result of lower import prices should not be bad news for Japan’s economy.
Just to remind folks, the problem of deflation is actually a problem of the inflation rate being too low. Since it is difficult to push nominal interest rates below zero, or at least much below zero, when inflation is low there are limits to how much the central bank can boost the economy with low real interest rates. When the inflation rate declines or turns negative due to a drop in oil prices or other imports, it does not affect the real interest rate as seen by firms. For this reason, the drop in import prices is not the problem implied by this article.
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