INTERNATIONAL MONETARY FUND
Deflation: Determinants, Risks, and Policy Options—Findings of an Interdepartmental Task Force1
Approved by Kenneth Rogoff
April 30, 2003
Contents

Page

I. Introduction and Summary .....................................................................................................4
Task Force Conclusions.....................................................................................5
II. Measurement, Determinants and Costs.................................................................................6
A. Definition and Recent Experience ............................................................................6
B. Determinants .............................................................................................................9International Transmission of Deflation ..........................................................11
C. Costs of Deflation....................................................................................................12
Collateral and Balance Sheet Effects...............................................................13
Sticky Wages ...................................................................................................13
Deflation versus Inflation or Disinflation ........................................................14
III. Historical Experiences of Deflation and Policy Lessons...................................................15
Deflation in the Nineteenth Century ................................................................16
Deflation in the Early 20th Century..................................................................17
IV. Risks of Deflation ..............................................................................................................18
A. Global Deflationary Pressures ................................................................................19
Price Indicators................................................................................................ 20
Excess Capacity and Output Gap Indicators....................................................20
Asset Market Indicators ...................................................................................21
Credit and Money Indicators ...........................................................................21
Aggregation and Weighting............................................................................. 221

The Task Force was instituted by Kenneth Rogoff in conjunction with David Burton,
Michael Deppler, and Anoop Singh. It comprised, and this study was prepared by,
Manmohan S. Kumar (Head), Taimur Baig, Jörg Decressin, Chris Faulkner-MacDonagh
and Tarhan Feyzioglu. It undertook the bulk of its investigation from December 2002 to
March 2003.

-2-

B. Overall Assessment .................................................................................................22
C. Deflationary Pressures in Major Economies...........................................................25
United States ....................................................................................................26
Germany...........................................................................................................27
Japan ................................................................................................................28
Other G-7 Countries.........................................................................................29
D. China .......................................................................................................................30
China’s Trade Share and Transmission of Deflation.......................................30
V. Policy Response ..................................................................................................................31
A. Policy Before the Onset of Deflation......................................................................32
B. Policy Once Deflation Has Set In ...........................................................................35
Text Tables
1a.
Incidence of Deflation and Low Inflation: Consumer Prices........................................ 8
1b.
Incidence of Deflation and Low Inflation: Producer Prices.......................................... 82a.
Index of Deflation Risk, with Latest Data (Weighted)................................................ 23
2b.
Index of Deflation Risk, with Latest Data (Equal Weight)......................................... 23
3aIndex of Deflation Risks (1995) (Weighted)............................................................... 24
3b
Index of Deflation Risks (1995) (Equal Weight).........................................................24
4.
Deflation Risk: Incremental Changes in Output and Unemployment Gaps................ 29
Figures1.
Aggregate Demand and Supply Shocks.......................................................................10
2.
Monetary Policy in a Liquidity Trap............................................................................11
3.
Inflation Target and Zero Bound..................................................................................33
Boxes
4.1
United States—Economic Outlook and Deflation Risks ............................................ 38
4.2
Deflationary Pressures in Germany ............................................................................ 40
4.3
Deflation in Japan ....................................................................................................... 42
4.4
China—Recent Deflation Episodes ............................................................................ 44
5.1
Inflation Targeting and Deflation Risks...................................................................... 45
Appendix I................................................................................................................................46
Charts1a.
CPI and GDP Deflator in G-7................................................................................... 48A1b.
CPI and GDP Deflator in Other Advanced Economies.............................................48B
1c.
CPI and GDP Deflator in Asian Economies..............................................................48C
1d.
CPI and GDP Deflator in Other Emerging Market Economies.................................48D
2a.
Goods Prices...............................................................................................................49A
2b.
Producer Prices...........................................................................................................49B
3.
Average Inflation Rates (CPI)..................................................................................... 50

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4.
5.
6.
7a.
7b.
7c.
8a.
8b.
9.
10.
11.
12a.
12b.
13a.
13b.
14.

Consumer Prices and Inflation..................................................................................... 51
Yield Differential Between Nominal and Index-Linked Government Bonds..............52
Commodity Prices........................................................................................................ 53
GDP Growth and Output Gap in G-7........................................................................54A
GDP Growth and Output Gap in Asian Emerging Market Economies.....................54B
GDP Growth and Output Gap in other Emerging Market Economies......................54C
Equity Prices in Industrial Countries........................................................................... 55
Equity Prices in Emerging Markets............................................................................. 55
Price Earning Ratios in Advanced Economies............................................................ 56
Real Effective Exchange Rates.................................................................................... 57
Private Sector Credit.................................................................................................... 58
Stock Markets (Comparison of Japan, U.S. and Germany- Monthly Data)................ 59
Real Residential Price Indices..................................................................................... 59
China’s Trade Shares................................................................................................ 60A
China–Regional and Global Trade............................................................................ 60B
China–Transmission of Deflation................................................................................ 61

References................................................................................................................................ 62

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I. INTRODUCTION AND SUMMARY
1. There has recently been a marked increase in concerns of a generalized decline in prices
in both industrial and emerging market economies. With Japan, China, and several other
Asian economies already experiencing declining prices, the worry has been that deflationarypressures could deepen, and even spread more widely. This is against a background of
massive declines in global equity markets; significant excess capacity and widening output
gaps; repeated disappointments over the pace of global recovery; geopolitical uncertainties;
and the impact on activity of higher oil prices.
2. This is the second time in the past five years that widespread concerns about deflation
have come to the fore—the first being during and in the aftermath of the Asian crisis. Public
discussion in many countries, including the United States and Germany, has centered on risksof the onset of deflation, with increasing attention levied to such risks by policymakers.
These developments are notable given that for over four decades markets and policy makers
have been more concerned about inflation than deflation.
3. In light of the above, an interdepartmental task force investigated issues related to thecauses and consequences of deflation, the conjunctural risks in individual economies andglobally, and policy options. This paper presents the findings of the task force and focuses onfour areas:•

Analytical Framework (Section II): This section discusses issues related to themeasurement, determinants and costs of deflation.

•

Historical Experiences (Section III): An evaluation is undertaken of deflation in the
19th Century and during the Great Depression, along with the recent experience ofJapan and China.

•

Risk Assessment (Section IV): A central part of the paper focuses on developing
and implementing a framework for assessing deflation risks using threecomplementary approaches. First, it computes an index of deflation vulnerability
based on a set of indicators for each of thirty-five of the largest industrial andemerging market economies—accounting for over 90 percent of global GDP. The
index reflects developments in aggregate prices, outputs gaps, asset markets, andcredit and financial markets. Second, an expectations-augmented Phillips curve
provides an estimate of the size of the deflationary shock (increase in output gap
and unemployment gap) that would be required for the onset of deflation, or
persistent deflation. Third, a case study examines China’s role in transmitting
deflationary impulse.

•

Policy Response (Section V): The section reviews options available topolicymakers both before and after the onset of deflation.

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Task Force Conclusions
Analytical Framework and Historical Experience
4. Both demand and supply shocks can lead to deflation. However, in the former casedeclining prices are likely to accompany falling demand for goods and services, while in thelatter, declining prices might be accompanied by increases in output. Nonetheless, deflationis seldom benign. Regardless of the source of the shock, it leads to a redistribution of income
from debtors to creditors. In addition, credit intermediation can be distorted as collateralloses value. Given the zero interest-rate floor, the effectiveness of conventional monetary
policy is curtailed—of particular concern when output is weakening. Persistent deflation
risks turning into a deflationary spiral of falling prices, output, profits, and employment.
5. Deflation can be costly, and is difficult to anticipate. Deflation was not uncommon in
the 19th Century, but even then its duration was often unanticipated. In the late 1920s andearly 1930s, U.S. policy makers exacerbated deflation by underestimating its consequences
and by failing to take aggressive action. In contrast, countries that exited the Gold Standard
earlier—such as Sweden and Japan—recovered from deflation relatively quickly.
Historically, deflation generally muted growth prospects, although it was mainly during theGreat Depression that the most severe effects of deflation were felt.
Risk Assessment
6. Based on the Index of Deflation Vulnerability, the risk of an onset of deflation in a
number of economies is seen to be relatively high and has drifted upward over the past
several years. The risk occurs against a background of post-war low inflation rates; large
output gaps; bursting of the equity price bubble; rising banking sector stresses in some
economies; and declining credit growth.
•

Asian economies, Japan in particular—but also Hong Kong SAR and Taiwan
Province of China—are at risk of worsening deflation. Deflationary expectations
appear to be entrenched, and in Hong Kong SAR, policy is constrained. In China,
the strong pace of activity and policy stimulus already in the pipeline are likely tocontain deflation. However, strains may arise in China from the large pool ofunderutilized labor and excess capacity in many sectors.

•

In the euro area, core inflation has been slow to decelerate, and except for Germany,risk of deflation remains low in the major countries. Germany suffers from a weak
macroeconomic environment, large and increasing output gap, high unemployment,
and banking-sector strains, with limited policy options. Outside the euro area,
Switzerland appears to have a moderate risk but—unlike Germany—there is greater
scope for policy measures.

•

In the United States, despite the lingering effects of the bursting of the equity pricebubble, risk of deflation appears relatively low. The lower risk reflects an expected
narrowing in the output gap; relief provided by a recent depreciation of the U.S.

-6-

dollar; the resilience in the financial sector; the availability of policy stimulus; andthe explicit willingness of policy makers to take preemptory action.
•

The task force did not find evidence to support strong concerns of generalized
global deflation.2 It also did not see any compelling evidence of widespreadinternational transmission of deflation. However, the high correlation of businesscycles across countries creates a non-zero, but still low, probability of asimultaneous decline in prices.

Policy Response•

Policies can be effective in warding off deflation, but only if preemptive, forceful,and sometimes unconventional steps are taken. Correspondingly, deflation is more
likely, or more likely to be persistent, when policy is constrained, or not sufficiently
forward-looking, or when policymakers are too dismissive of their ability to act.

•

It is better to prevent deflation than to try to cure it, and monetary policy must takethe lead. Since the risks of deflation are asymmetric, policy must be attuned todeflationary impulses in a low inflation environment. Further, because these
impulses can also impede the monetary transmission mechanism, aggressive action
is required. At the zero bound on nominal interest rates, additional unorthodox
measures may be needed. Stimulatory fiscal policies can play an importantcomplementary role; their beneficial effects could be enhanced if measures are
adopted to raise the rate of return to the economy, so as to spur investment andoutput. Structural reforms, particularly those improving credit intermediation, could
also be beneficial.
II. MEASUREMENT, DETERMINANTS AND COSTS
A. Definition and Recent Experience

7. Deflation is defined as a sustained decline in an aggregate measure of prices such as theconsumer price index or the GDP deflator. One or two quarters of price declines, while
technically constituting deflation, would not be worrying. However, even mild but
continuous deflation could be a cause for concern, as it may increase economic uncertainties,
distort resource allocation, entail distributional consequences, and lead to subpar growth
performance. This definition precludes characterizing deflation in terms of changes inrelative prices. In any economy, there will always be sectors where prices are falling in
relative, or even absolute, terms. This reflects the normal operation of the market
2

The SARS epidemic could have substantial demand side effects with adverse consequences
for the pace of activity and deflationary pressures in several countries. The analytical work inthis report was completed before the extent of the fall out from SARS was recognized.

-7-mechanism, whereby changes in sectoral prices play a central role in resource allocation.3
8.
In a number of industrial and emerging market economies, broad indices of goods prices
have recently been declining (Charts 1 and 2 and Roach, 2002a). But with the weight of goodsin CPI falling over time (averaging around only 25 to 35 percent in the G-7 economies) andservices playing an increasingly important role, it is not clear that deflation in tradable goods
sectors per se ought to be a concern. It has been suggested that deflation in goods prices may
be a harbinger of developments in the services sector, since many service activities which
previously had been essentially domestic oriented or shielded from competitive pressures are
no longer so (Roach 2002b). This has been particularly evident in the case of financial andtelecommunications services, but it now applies to several others also. However, there iscurrently little convincing evidence of a broad-based decline in services prices.
9.
The impact of large asset price declines on balance sheets and aggregate demand issometimes associated with deflation. For example, the U.S. stock market crash in 1929
presaged a period of widespread bankruptcies, collapsing demand and prices, and ultimately
the Great Depression. The decline in Japanese equity and land prices in the early 1990s has
been associated with a prolonged slide in activity and deflation. As Kiyotaki and Moore (1997)
show, asset price declines have a severe impact on credit-constrained firms: the declines canspill over from one sector of the economy to another, and their effects can persist over time andbecome magnified. Nonetheless, while sharp declines in asset prices may reflect a heightened
vulnerability, such declines by themselves do not constitute deflation (Bordo, 2002).4
10. Although the CPI is used as the main indicator of deflation, it is subject to a variety ofbiases. In almost all countries, consumer price indices are “Laspeyres” base-weighted, andhence do not allow for substitution possibilities. A second source of bias can arise when shifts
to lower price discount outlets are inadequately reflected. A third element relates to new or
improved products, whereby prices included in the CPI inadequately reflect these products’
characteristics. The magnitude of the overall bias due to these three factors varies acrosscountries, but is generally perceived to range between ½ to 1 percentage point.5
3This definition would also exclude the impact on the general price level of terms of trade
shocks, such as a decline in oil prices whose effects might be beneficial, but also temporary.
4

Falling house prices may be accompanied by falling rental costs, which may impact
standard measures of inflation. However, even if the decline in rents, or the rental
component, is large, this by itself would not be expected to result in deflation.
5

In the United States, the first two were estimated to overstate inflation by up to
0.4 percentage points, and the third added as much as another 0.7 percentage points. While
recent changes to the methodology for computing the U.S. CPI have helped to reduce someof the bias, Hausman (2002) suggests that these improvements fix only secondary issues, andthat substantial bias still continues. Ariga and Matsui (2003) suggest that Japanese CPI may
have an upward bias of at least ½ percentage point.

-8-

11. In view of the measurement bias, it is likely that measured inflation of less than 1 percent
may already be close to price stability, or even reflect declining prices. Table 1a provides anillustration of the incidence of declining prices and inflation below 1 percent for a large sample
of industrial and emerging market countries. The estimates show a sharp increase in the
proportion of country-months showing annual CPI inflation of less than 1 percent over the past
five years. While the higher incidence first became apparent during—and in the aftermath of—
the Asian crisis, it has continued over the past three years, especially in emerging markets. A
similar picture holds with regard to the more cyclically volatile PPI inflation (Table 1b).
Table 1a. Incidence of Deflation and Low Inflation1 : Consumer Prices(in percent)Deflation and Inflation less than 1 percent

All Countries
Industrial Countries
Emerging Countries

1980-84

1985-90

1991-96

1997-02

1997-99

2000-02

1.8
0.1
3.2

9.8
11.8
8.3

5.0
10.2
1.4

23.5
23.7
23.4

24.8
31.0
20.7

22.3
16.3
26.3

Deflation

All Countries
Industrial Countries
Emerging Countries

1980-84

1985-90

1991-96

1997-02

1997-99

2000-02

0.9
0.0
1.6

3.2
3.7
2.8

1.2
2.5
0.3

11.4
7.4
14.1

9.7
6.5
11.9

13.1
8.3
16.3

Table 1b. Incidence of Deflation and Low Inflation1 : Producer Prices(in percent)Deflation and Inflation less than 1 percent

All Countries
Industrial Countries
Emerging Countries

1980-84

1985-90

1991-96

1997-02

1997-99

2000-02

12.8
8.3
17.2

27.4
36.0
19.6

29.0
45.5
16.5

40.8
57.2
28.7

45.3
66.2
30.2

35.7
47.3
27.0

Deflation

All Countries
Industrial Countries
Emerging Countries
1

1980-84

1985-90

1991-96

1997-02

1997-99

2000-02

8.0
2.6
13.3

21.7
27.4
16.5

19.1
30.0
10.9

29.1
37.9
22.7

34.0
45.1
26.0

23.6
29.9
18.9

Number of country months with yoy inflation less than 1 percent or negative, as a percent of total.
Data based on 35 of the largest industrial and emerging market economies.

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12. The incidence of an actual decline in prices has also increased markedly in recent years.
The number of countries experiencing a decline in consumer prices rose from around 1
percent in the first half of the last decade, to over 10 percent in the last five years (Table 1a).
The proportion has continued to increase in the most recent period for both the industrial andemerging market economies. Although less dramatic, there has also been a noticeable
increase in incidence of PPI deflation, particularly in emerging markets, in the last five years(Table 1b).
13. The background to the increased incidence of deflation is the decline in inflation rates
over the past decade (Charts 1 and 2). Among industrial countries, CPI inflation has declined toan average of below 2 percent, a rate not seen since the 1950s (Chart 3). Even among emerging
market economies, inflation rates are now at their lowest level since detailed data became
available in the late 1960s. Low inflation confers significant economic benefits, but it also
reduces the buffer against deflation and against hitting the zero bound on nominal interest
rates. This raises a number of questions, discussed below, regarding factors that can lead an
economy to move from disinflation to deflation, and the costs of deflation.
B. Determinants
14. The onset and persistence of deflation can reflect a variety of factors. Consider an
economy initially at a full-employment equilibrium (π*,Y*), given by the intersection of
aggregate demand (AD) and aggregate supply (AS) (Figure 1). A sufficiently large negative
demand shock that shifts the aggregate demand from AD to AD′ can push the economy to a
deflationary region (π**, Y**) with declining prices and lower output. Such a shock could
reflect a severe cyclical downturn, the bursting of an asset price bubble, or excessively tightpolicies. The effects of the shock could be amplified through a deterioration in confidence
and expectations of declining prices, exacerbating the initial deflationary impulse. The
alternative to a demand shock is a positive supply shock that shifts the aggregate supply
curve downwards to AS′ where output is higher, even while prices are declining (π′, Y′).
Positive supply shocks can arise from a variety of factors including technological innovationand productivity growth, gains from trade liberalization, or heightened expectations of longterm political and economic stability. An economy may be subject to a combination ofdemand and supply shocks that could exacerbate the deflationary pressures but ameliorate theeffects on output (πc, Yc).
15. Once prices start declining, the risk of adverse dynamics is heightened, particularly inthe case of a demand shock. Following such a shock and the onset of deflation, nominalinterest rates will likely decline. However, given the zero bound on nominal rates, realinterest rates will remain positive, and the greater the deflation, the higher the real rates.
Monetary policy loses efficacy since demand for money is more or less infinitely elastic atinterest rates close to or at zero. In terms of the standard IS-LM framework, this implies that
if the IS curve intersects the LM curve at the latter’s flat region, increases in money supply
would shift the LM curve to the right to LM′, but have no impact on the interest rate or
output (Figure 2). This is the classic liquidity trap.

- 10 -

Figure 1: Aggregate Demand and Supply Shocks

╥
AS

AS’

╥*
0
╥**
╥’

Y’

Y**
Y*

Y

Yc

AD

╥c
AD’

16. From an inter-temporal perspective, the liquidity trap holds because of entrenched
expectations in the presence of nominal rigidities (Krugman, 1998). As long as agents do notbelieve that the future path of money supply will be changed, they will not respond to current
increases in money supply which they deem to be temporary. This can then become thefundamental challenge to policy in a deflationary environment—to credibly promise to raise
the price level not only in the present, but in the future as well (Eggertsson and Woodford,2003).
17. The role of expectations is crucial in the persistence of deflation. Suppose that as aresult of an adverse demand shock, the price of current goods relative to the price of future
goods (P/Pe) is too high, reducing expenditures today in favor of higher (expected)
expenditures tomorrow. This means that the economy has an excess of saving overinvestment in the current period (Krugman, 2002). The equilibrium could be attained bylowering P or raising Pe. However, once the current price level begins to decline, theexpected price level may also begin to decline, and activity slows further. As a result, theoutput-inflation dynamic itself can change. There is a possibility that the Phillips curve
flattens, with the result that the aggregate demand shock leads to large declines in output andemployment without initially having much impact on prices (Nishizaki and Watanabe, 2000).

- 11 -

But pronounced weakness in activity may be followed by an increasing downward pressure
on prices. A deflationary spiral can thus form as declining prices reinforce expectations about
future price developments.

Figure 2: Monetary Policy in a Liquidity Trap
I
IS

LM

LM’

Y

IS

International Transmission of Deflation
18. Deflationary impulses can be transmitted across countries. This was not an uncommon
occurrence under the Gold Standard. However, in a global economy with generally flexible
exchange rates and independent policy regimes, a generalized international propagation of
deflation appears unlikely.
19. The scope for bilateral transmission of deflation may also be limited. Suppose an
economy is witnessing rapid productivity growth, and has large excess capacity relative to its
trade competitors. Its unit costs of production will be rising at a slower rate than thecompetitors’, giving it an advantage in the tradable goods sectors. This would lead to anincrease in its market share, and depending on the size of the tradeable goods sectors could
result in a large demand shock for the competitors. In response, the latter may need adepreciation of the real exchange rate, which would normally be achieved by a combination

- 12 -of nominal exchange rate depreciation and lower domestic unit costs (and prices).6 If thenominal exchange rate does not adjust adequately, the burden of adjustment would be on
prices. This may cause significant dislocation in these sectors, especially if there are
structural rigidities that prevent a reallocation of resources. However, it is unlikely that thisprocess could lead to generalized deflation, given the share of trade (actual and potential)
accounted for by any single country, and the possibility of offsetting policy measures. Also,
high growth in the large economy could boost demand for imports from the competing
economies, partially mitigating the adverse shocks.
20. Another important impact of an economy undergoing rapid productivity growthexperiencing a decline in unit costs and export prices will be significant terms of trade gains
for its trading partners. This would be reflected in an increase in real incomes and demand
growth, which could have substantial positive multiplier effects. These effects could mute theimpact of deflationary pressures noted above, depending on the share of tradables in
consumption in the importing countries.
C. Costs of Deflation
21. Assessing precisely the costs of deflation is challenging. First, the effects on output offalling prices per se have to be isolated from those of other factors, such as declining equity
prices or rising risk premia. Second, it is necessary to quantify the cost of falling prices interms of output losses. Nonetheless, there is considerable theoretical and empirical evidence
to suggest that deflation can be a cause for concern.
22. The costs of deflation depend on its source as well as on its extent and duration.
Deflation may not entail significant costs and be accompanied by growth in output undercertain circumstances. These include temporary price declines due to a strong expansion inaggregate supply, as for instance, following a productivity spurt, falling import prices,aggressive trade liberalization, or other positive external shocks. Under such circumstances,deflation is the manifestation of an adjustment to a new equilibrium in the context of risingincomes. It is thus unlikely to become anchored in agents’ expectations and have sustaineddeleterious effects on domestic demand and the pace of activity. Recently, the IT revolution,
globalization, and deregulation have given a boost to productivity growth across a broad
range of goods and services sectors, reducing inflationary pressures. Similar episodes of
productivity spurts are believed to have played an important role in deflationary episodes
during the 19th century (see below).
6

In the usual Balassa-Samuleson framework, a positive productivity shock in the tradeable
goods sector is expected to lead to an appreciation of the real effective exchange rate as anequilibrating mechanism. This adjustment, however, happens over a period of time.
Moreover, this mechanism could be impeded in certain circumstances because of thepresence of large excess capacity and underutilized pool of labor, resulting in the persistenceof the shock.

- 13 -

23. However, aggregate demand driven deflation is likely to entail significant costs, in part
because of various nominal rigidities. These rigidities can be traced back to financial
intermediation, including the zero-interest rate floor, as well as in the labor market. While theestimates due to the former are considered to be significant although difficult to quantify
precisely, studies of the downward rigidity of nominal wages suggest that deflation could
impose costs amounting to several percentage points of GDP (Akerlof et.al., 1996).
Collateral and Balance Sheet Effects
24. In a period of deflation, particularly if unanticipated, the losses of the debtors may notcancel out against the gains of the creditors because collateral loses value. The loss incollateral may be particularly severe when deflation is accompanied by sizable reductions inasset prices.7 The wholesale disposal of collateral could also intensify downward pressure on
asset prices. As collateral loses value and bankruptcies ensue, banks need to reevaluate theirloan portfolios but may find it hard to distinguish between good and bad risks. As a result,they either raise financing charges (the external finance premium rises) or they cut back on
lending that they might otherwise have undertaken, resulting in a fall in aggregate demand.
25. By reducing collateral from firms’ balance sheets, deflation also reduces theeffectiveness of monetary policy in escaping from deflation. Near the zero bound, the policydetermined interest rate plays a less important role in determining the borrowing cost, since
the external finance premium becomes increasingly important. In an extreme situation, theeconomy can end up in a debt-deflation trap. The balance sheet channel also explains why
deflation from a positive supply shock may not be as deleterious as from a negative demand
shock since rising output and incomes can help offset some of the effects of deflation onbalance sheets.
Sticky Wages
26. Aggregate demand-induced deflation can reduce employment when nominal wages are
rigid downwards. With sticky wages, price declines cause real wages to rise, profit margins
to fall, and employment to be cut back. This may set off a deflationary cycle. Akerlof et al(op.cit.) calculate that with 1 percent annual rate of deflation and downward rigidities innominal wages, unemployment in the United States could rise from a long-run equilibrium
rate of 5.8 percent to 10.0 percent. Cumulative output losses could amount to a multiple of
the roughly 4 percentage point loss in employment. Most other studies of nominal wage

7

As deflation raises the real value of outstanding debts contracted in nominal terms while itgenerally does not raise debtors’ real capacity to service their debts, it can lead tobankruptcies which may entail real economic costs. This effect—based on Fisher’s (1933)
debt-deflation-theory— hinges on the assumption that deflation is not fully anticipated.

- 14 -

setting, while uncovering significant rigidities, estimate the costs to be less important but still
far from insignificant.8
27. While sticky wages may be destabilizing in response to sustained aggregate demand
shocks, they could stabilize output in response to temporary shocks (Keynes, 1936 andTobin, 1975). DeLong and Summers (1986) show that by inhibiting expectations of sustained
price declines from becoming anchored (because consumption is sustained and likelihood of
increases in ex-ante real interest rates is forestalled), sticky wages may help prevent a
deflationary cycle. This may also suggest why structural factors—such as the introduction ofa legal minimum wage, unemployment benefits, and support for low income groups—havebeen associated with a decline in the cyclical volatility of output. However, the failure ofwages to adjust in response to sustained declines in demand would eventually lead to rising
unemployment and the costs noted above.
Deflation versus Inflation or Disinflation
28. Because of the imperfections in financial and labor markets, the costs of deflation andinflation––particularly if unanticipated––are not symmetric, regardless of the underlying
economic shocks. The costs in terms of efficiency losses for resource allocation and anincrease in uncertainty from moving from zero to very low inflation rates (below 2 percent,say) are likely to be negligible.9 In contrast, the adverse effects due to sustained mild
deflation can be substantial.
29. Deflation and disinflation have some similar effects on activity but, because of market
imperfections, deflation entails higher costs. The zero interest rate floor is more likely to
become a binding constraint under deflation than disinflation; the same holds for wage
rigidities at the zero bound. Furthermore, the “collateral” and “balance sheet” effects may
well be stronger under unexpected deflation than disinflation. For example, assessments ofcreditworthiness typically place a disproportionate weight on the latest loan-to-asset values
or loan-to-income/profit ratios. While the fundamental ability of a debtor to service a loan
may deteriorate to the same degree under unexpected deflation as under unexpected8

On the United States, see McLaughlin (1994), Akerlof et.al, (1996), Card and Hyslop(1997), Kahn (1997), and Altonji and Devereux (1999); for the United Kingdom, see Smith(2000) and Nickell and Quintini (2000); and for Germany, see Decressin and Decressin(2002). A caveat is that the behavior of nominal wages during periods of inflation––which ismost of the available evidence––may be different from the behavior of nominal wages inperiods of deflation: some of the available evidence suggests that wage rigidity may be
reduced during deflation.
9

The arguments about the asymmetry in costs of deflation and inflation underscore theimportance for policymakers to target an appropriate inflation rate. See Part V for a
discussion of this issue.

- 15 -

disinflation, banks are more likely to cut credit lines under deflation for fear of notrecovering the book value of the loan principal. Furthermore, the disintermediation that may
follow the financial distress triggered by unexpected developments in prices may be larger
under deflation than under disinflation (for historical evidence on the complementarity
between price and financial stability, see, for example, Bordo et. al., 2001).
III. HISTORICAL EXPERIENCES OF DEFLATION AND POLICY LESSONS
30. In view of the above discussion of the determinants and costs of deflation, it is useful to
examine the empirical evidence regarding persistent deflation. Prior to the onset of deflationin Japan from mid-1990s onward, there had been few sustained deflationary episodes in the
post-Second World War period in the major economies. Among industrial countries Canada,
Norway and Sweden had small and short-lived declines in consumer prices in the late 1980s;
and the private consumption deflator fell in Germany in 1986 (mainly due to a supply shock)and in Japan in 1988. Several Scandinavian countries experienced a bursting of an asset
price bubble, a sharp decline in output and severe banking sector distress in the late 1980s
and early 1990s. However, these were not generally accompanied by falling aggregate prices.
A number of emerging market and developing countries also experienced declines in prices
up to the mid 1990s. But the declines were generally short-lived reflecting natural disasters
or severe declines in terms of trade of commodity exporters (IMF, 1999; the CFA Franc Zone
countries have experienced similar price shocks). Nonetheless, as noted earlier, the frequency
of price declines in both industrial and emerging market countries has been clearly increasingover time.
31. For an assessment of periods of pronounced and sustained declines in prices, it istherefore necessary to consider the pre-Second World War period. The discussion below
focuses on two periods: the experience of industrial countries during the last quarter of thenineteenth century when mild but persistent deflation in the first half of the period was
followed by inflation in the second half; and second, the experience of the United States,
Japan, and Sweden in the 1930s when severe deflation lasted for a shorter period, but was
accompanied by far severe consequences.10
32. A review of the historical episodes yields three main conclusions: first, deflation anddeflationary expectations can take root surprisingly quickly; second, deflation can impose
severe economic costs, unless it reflects primarily positive supply shocks; and third,

10

The recent experience of Japan, where mild deflation has been accompanied by nearstagnation in output, and a very different experience of China where less persistent deflation
has been accompanied by strong productivity gains and output growth are examined in
Section IV below.

- 16 -

determined and vigorous policies can make a critical difference to ending deflation
effectively and relatively quickly.11
Deflation in the Nineteenth Century
33. From a broader historical perspective, secular increases in the aggregate price level are verymuch a phenomenon of the second half of the twentieth century.12 For much of recorded history,
prices rose because of supply shocks, including military conflicts or harvest failures, but
abstracting from these factors, prices were as likely to increase as decline: there were few
episodes of sustained inflation. Over the nineteenth century as a whole, there was a marked
decline in the aggregate CPI in several major economies (Chart 4). In the United States, the CPI
index in 1900 was around half its value in 1800; in the United Kingdom, it was a third lower.13
34. Prices declined in large part because of the constraints imposed by the Gold Standard inan environment in which there was a significant excess demand for gold. Increasing demand
for money was being driven by technological change and population growth. At the sametime, the supply of gold was largely fixed. The constraints imposed by the limited supply ofgold manifested in part in the deflationary episodes and relatively weak growth: despite theextraordinary technological revolution, annual U.S. real GDP growth per capita was justabove 1½ percent over the entire century; in the U. K. it was just under 1 percent.
35. Although there is some debate on the precise effects of deflation specifically during thelast quarter of the nineteenth century, there is a broad consensus on the following: (i) periodsof deflation were generally associated with significant social and political unrest as producers(especially farmers) faced rising debt burdens and bankruptcies; (ii) there was significant
volatility in output growth, with deflationary periods marked by frequent financial crises; and(iii) periods of inflation, such as the last decade of the nineteenth century, had generally
higher growth than periods of sustained deflation during the decade of the 1870s and early
1880s (Lindert and Williamson 1985, Frieden 1993, and Bordo and Redish 2003).
36. Nonetheless, GDP growth was on average positive in periods of deflation. There are
two main explanations for this: First, periods of declining prices occurred at times ofrelatively favorable supply shocks. These included major episodes of diffusion of newtechnologies including the spread of railways and electrification. Second, prices did not falllong, or far, enough to lead to expectations of a deflationary spiral becoming entrenched.
11

The lessons from Japan’s recent experience are consistent with these three conclusions andare discussed in Section V below; for details, see Bayoumi and Collyns (1999).
12

Why this is so is much debated. But one of the key reasons may well be the existence of
discretionary monetary policy.
13

Taking an even longer period, the aggregate price level in the United Kingdom and theUnited States was virtually the same in 1900 as in 1700.

- 17 -

This hypothesis is supported by the behavior of long-term interest rates that did not fall
during deflationary episodes. Furthermore, financial intermediation played a less crucial rolein the nineteenth century, and nominal rigidities likely were less entrenched than today(Bordo et al, 2000).
Deflation in the Early 20th Century
37. Deflation in the late 1920s and early 1930s was qualitatively and quantitatively
different than that during the 19th century. In the United States, the consumer price index(and the GDP deflator) declined by 24 percent from August 1929 to March 1933, after
having been virtually flat from 1921 to 1929. This decline was accompanied by a fall in real
GDP of almost 30 percent. Similar price declines occurred in other countries; from 1929 to1933, prices fell by 25 percent in Japan and 20 percent in Sweden.
38. In contrast to the 19th century, a collapse in aggregate demand and credit channels,
along with policy mistakes, drove deflation of the late 1920s and early 1930s. There is broad
agreement that monetary factors played a crucial role both in the onset and prolongation of
deflation and in the accompanying Great Depression. Friedman and Schwartz (1963) showthat the initial downturn in August 1929 and the length and severity of the Great Depression
were due to restrictive monetary policy that resulted in a drastic decline in money supply.
Bernanke (1995) has emphasized disruptions to the bank intermediation channel—andEichengreen (1995) the international financial channels. These factors are now generally
reckoned to be more important than the stock market crash per se.14
39. Obstfeld and Rogoff (1996) emphasize that there is a broad consensus that the
Depression was caused by an “exogenous world-wide contraction, originating mainly in the
United States and transmitted abroad by a combination of policy errors and technical flaws
in the interwar gold standard”. This conclusion is also supported by the clear divergence ineconomic performance between countries that abandoned the gold standard early in the
Depression and others that stubbornly clung to gold.
40. In the United States, the Federal Reserve made two policy mistakes. First, it saw theinitial collapse in prices and demand as “necessary” to correct excesses of the 1920s. It
regarded the collapse as a result of nonmonetary forces— including creation of excess
capacity in the late 1920s—and beyond the influence of monetary policy. The large numberof bank failures in 1930 were according to its view the result of poor management andlending for speculative equity and land deals. Second, it tried to maintain the gold standard.
While the Federal Reserve did ease, it paid no attention to the money supply. The discount14

In addition to the latter two, the unequal distribution of income and wealth has also been
noted to be a factor.

- 18 -

rate fell from 6 percent in early 1930 to ½ percent in the first part of 1931.15 However, banklending had virtually stopped, and along with the high rate of deflation, real interest rates
rose sharply. The gold standard was maintained until 1933.
41. Sweden and to some extent Japan provide examples of policymakers that were able tobreak deflationary forces through strong action.16 Sweden experienced similar, althoughsomewhat less pronounced, deflation as the United States in the late 1920s. Consumer prices
had been falling gradually, and wholesale prices sharply, since late 1928 as the gold standardtransmitted deflationary pressures to Sweden. Industrial production declined by 21 percent
during 1929-31, compared to a fall of 46 percent in the United States. In late 1931 Sweden
left the gold standard, the Swedish central bank explicitly adopted a price level target, andimplemented a policy including open market operations to achieve that target. The
abandonment of gold standard itself was an immense boost to confidence and a signal thatthe government was not prepared to allow deflation to continue. This was supported by theprice level targeting framework underlining the government’s determination to end deflation.
As Berg and Jonung (1999) show, there was a clear recognition that the Riksbank’s
commitment to price stability would anchor expectations.
42. Japan was also able to stop deflation by adopting strong measures. It had temporarily
returned to the gold standard in 1929, but by 1930-31, there were sharp declines in Japanese
exports, resulting in output declines and rapid deflation. Wholesale prices declined by about
30 percent in 1930-31. The gold standard was abandoned in December 1931, followed byexchange rate depreciation, a marked easing in monetary policy and large-scale government
deficit spending. The Bank of Japan underwrote a substantial proportion of the government’s
bond issuance. These measures led to a sharp rebound in Japanese domestic demand and an
end to deflation; wholesale prices rose substantially during 1932-33. However, in the absenceof a clear commitment to price level targeting as in Sweden, and the rapid increase ingovernment spending and monetization of deficits driven by war mobilization, inflation
accelerated markedly in the second half of the 1930s.
IV. RISKS OF DEFLATION
43. This section provides an assessment of conjunctural deflation risks in the world
economy. It shows that deflationary pressures have risen in several countries, and the15

The discount rate was temporarily raised in response to Britain’s abandonment of gold
standard in September 1931.
16

It should be remembered that gold had anchored exchange rate and monetary policy fornearly two centuries. Policymakers thought it inconceivable that, aside from the occasional
revaluation, the exchange rate could float freely. Bernanke (1995) notes that the gold
standard and austere fiscal policies were central tenets of the French political establishment;so much so that even the Communist party in the 1930s accepted the need for them.

- 19 -

susceptibility to deflation is high in some of them. Moreover, the global economic
environment continues to be highly uncertain not least owing to the significant declines inequity markets, large and possibly rising output gaps, and geopolitical concerns. These
factors could increase vulnerabilities further. Nonetheless, it shows that the deflationarypressures are not strong enough to lead to generalized global deflation. The assessment isbased on an index of deflation vulnerability computed from a set of economic and financial
indicators for 35 countries. The index is complemented by an analysis based on expectations
augmented Phillips curves for the G-7 economies, and a case study of China.
A. Global Deflationary Pressures
44. As Section II suggested, sustained deflation can be unanticipated even as inflation andinterest rates fall close to zero. Spotting deflationary pressures is difficult since the aggregate
demand shocks that push an economy into deflation may be confused with the “normal”
business cycle.17 Moreover, the magnitude and effects of supply shocks may be unclear froman assessment of the price level alone. Thus a comprehensive set of indicators is required to
identify deflationary pressures. The analysis in the previous sections also suggests thatdemand-driven deflation is more damaging than supply-driven deflation, so the indicators areprimarily focused on demand shocks. Deflation driven by demand shocks may also be easier
to detect. Demand-side variables are generally available at high frequencies, and they tend tomove in the same direction as deflationary forces (falling prices are associated with falling
output). In contrast, supply-driven deflation can be harder to discern, either because theeconomy appears to be improving (for example, output gaps may be closing or be positive,
while prices are falling), or because supply-side data are available only with long lags and at
relatively low frequencies (such as rates of return).18
45. The earlier analysis suggests four sets of indicators: (i) aggregate prices; (ii) measuresof excess capacity, or output gap (iii) asset markets; and (iv) credit market and monetary
indicators. In addition, structural characteristics, and the room for maneuver on the policy
front play a role in the overall assessment.
46. For each of the four sets of indicators, several variables were used to assess deflation
vulnerability. The variables, discussed below, were computed from the early 1990s to thepresent for thirty-five of the largest industrial and emerging market economies. For eachvariable, an examination was undertaken as to whether the variable exceeded apredetermined threshold; if it did, the economy was given a score of 1 on that count;17

Ahearne, et. al. (2002) highlight optimistic growth forecasts for Japan that ultimately
proved to be mistaken, but caused policymakers to forestall action. In the United States, the2001 recession was not reflected in national accounts data until July 2002, a full 16 months
after the recession had started.
18

Of course, a focus on demand-side indicators would make it difficult to take into accountforces that predominantly reflect positive productivity shocks.

- 20 -

otherwise, 0 (see Appendix for details). The thresholds were determined on the basis of avariety of considerations and were cross-validated with Japan’s experience in the mid1990s.19 The scores were aggregated to compute the index. In order to account for theheterogeneity across countries in the importance of asset and credit markets, a weighted
index was also computed. The discussion below first notes developments in each set ofindicators, and then looks at the construction of the aggregate index.
Price Indicators
47. Consumer and producer price inflation is at post-war lows in many countries. However,inflationary expectations generally remain well anchored (Chart 5). According to both
Consensus and IMF staff projections, very few countries are expected to register consumer
price inflation of less than one percent: outside of the Asian region, these encompass only
Germany and Switzerland. Although global oil prices have recently declined sharply, thelagged effects of the earlier higher prices could be reflected in an uptick in headline inflation
rates in the near-term (Chart 6). 20 However, higher oil prices are also likely to have had
adverse effects on activity which may increase deflationary expectations. Given the difficulty
in predicting deflation and the measurement bias, price indicators with a low value (inflationof less than ½ percent) were taken as a worrying sign (see Appendix).
Excess Capacity and Output Gap Indicators
48. Excess capacity may be acting as a drag on growth in several G-7 and smaller industrial
economies. GDP growth is below potential in several of these economies, and is expected toremain so (Chart 7a). From a long-term perspective, if overcapacity were a significant drag,the rate of return on capital should fall. However, in the largest economies, only Japan is
showing a sustained decline in the return on capital (corporate profits as a share of thebusiness capital stock).
49. In emerging market economies, particularly in Asia, evidence points to excess capacity
in a number of economies, and in specific sectors. Staff calculations suggest that output isbelow potential in Hong Kong SAR, Singapore, Brazil, Poland, and Russia (Charts 7b-7c).
Output gaps could be increasing in these countries, in particular in Singapore and Brazil. In
19

Given the limited number of recent deflationary episodes, it was not possible to estimate
the thresholds using the usual econometric techniques. The thresholds were derived insteadfrom the recent experience of Japan, an assessment of factors underlying deflation in Hong
Kong SAR, and from other empirical evidence (for instance on the relationship between
output gap and inflation). A number of simulations were undertaken by varying the size ofthe thresholds: the findings indicated a high degree of robustness of the results.
20

There may also be some impact of increases in non-oil commodity prices, particularly
grain and agricultural raw materials. With generally large inventories, metals prices havecontinued to be weak.

- 21 -

China, surveys suggest high excess capacity in several state dominated industries, which may
be increasing given strong private and public investment.21
Asset Market Indicators
50. Since early 2000, equity markets have suffered exceptionally large corrections (Charts8a-b). Price-earning ratios have returned to close to historical averages in several G-7
economies. However, earnings projections in many cases may still be overoptimistic—
exposing downside risks (Chart 9). Over the same period, house prices have risen
considerably across several countries, sustaining household balance sheets. Conversely, thedecline in house prices in Japan, and to a lesser extent Germany, has aggravated the adverse
effects of declining stock prices. Stock markets in emerging market economies have also
declined significantly: the MSCI index of emerging market equities has fallen by over 50
percent (in U.S. dollar terms) since early 2000. The assessment of the deflationary impulse
from an equity price shock to household and corporate balance sheets took into account themagnitude of price declines, and the importance of equity markets in the economy.22
51. As in the case of asset price declines, an appreciation of the exchange rate has bothincome and balance sheet affects. An appreciated currency dampens activity and incomes inexport and import competing sectors, and puts downward pressure on prices, both directly
and through weaker activity.23 Given the differences in the extent and speed of exchange ratepass-through, a variety of measures were considered to proxy the effect on deflation via theexchange rate channel (see Appendix). The measure utilized was based on the degree ofappreciation of the effective exchange rate (Chart 10).
Credit and Money Indicators
52. Credit growth has slowed markedly in many industrial and emerging market
economies, failing even to keep pace with nominal GDP growth (Chart 11). This may largely
reflect weak demand, but in some cases could also be an indicator of elevated risk aversion
by banks, or emerging stress in the financial sectors. For example, in Japan the ongoing
contraction in credit reflects weak credit demand as firms seek to deleverage, as well as
worsening credit quality of borrowers; it may also, however, reflect a restriction in lending
21

For the non-OECD countries, output gap measures were obtained using a Hodrick-Prescottfilter to derive potential output series.
22

Given the lack of data on house prices in many countries, the formal analysis focused onequity prices, although changes in house prices were taken into account in individual country
assessments discussed below.
23

A striking exception may appear to be the U.S. dollar appreciation of the late 1990s, which
occurred during rapid economic growth without raising concerns about deflation. But it was
accompanied by a sharp increase in asset prices, reflecting higher expected rates of returns.

- 22 -

by creditors given the difficulty in determining creditworthiness. Several measures offinancial intermediation, including growth in broad monetary aggregates and credit were
utilized to assess the extent to which credit and money channels may be exerting deflationarypressures.24
Aggregation and Weighting
53. Two sets of indices were computed based on the raw scores: (i) an unweighted index
where the scores were aggregated and renormalized to one to yield the index; and (ii) a
weighted index where the financial and credit indicators were weighted according to theirrelative importance in the economy. For the weighting procedure, data regarding market
capitalization of the broader equity index as a share of GDP were obtained and countries
were divided into three cohorts along the lines of relative importance of equity markets. In
countries that have a relatively large equity market, changes in equity prices were given
greater weight than where equity markets are smaller. A similar scheme was used to reflect
the heterogeneity with regard to the financial sectors (see Appendix.)25
B. Overall Assessment
54. The country rankings for both unweighted and weighted indices suggest the following(Tables 2-3):

24
25

•

There has been a clear increase in the vulnerability to deflation for a number ofindustrial and emerging market economies. However, at this juncture, apart fromthe countries already beset with deflation, only a few additional countries appear tobe significantly at risk.

•

Japan ranks at the top of the list, and in Asia is followed by Hong Kong SAR and
Taiwan Province of China. China, despite ongoing deflation, ranks rather low
because, as noted above, the indicators used in the index have a demand-side focus.
This underlines the largely supply-side nature of China’s deflation which isfundamentally different from the mostly demand-contraction driven pressure on
prices seen elsewhere.

•

The score for the United States indicates a relatively low risk of deflation.
Nevertheless, there are considerable uncertainties with regard to the effects ofequity price declines still in the pipeline, excess capacity in several major sectors,
and the impact of security and geopolitical concerns.

Euro area countries were excluded in the application of money growth variable.

An effort was also made to control for country heterogeneity in the degree of openness totrade, and exchange rate pass-through. Unlike for the equity and credit market variables, theweighting scheme based on these factors did not substantially change the results.

- 23 -

Table 2a. Index of Deflation Risk, with Latest Data (Weighted)1
Risk/
Index

1

Minimal< 0.2
Australia
Chile
Denmark
Malaysia
New ZealandRussiaSouth Africa
Spain

Low
0.2 ≤ x ≤ 0.3
Austria
BrazilCanadaChina
FranceGreeceIndia
Ireland
Italy
Korea
MexicoNetherlands
PolandThailand
United Kingdom
United States

Moderate
0.3 ≤ x ≤ 0.5
Belgium
Finland
NorwayPortugal
Singapore
SwedenSwitzerland

High
> 0.5
Japan
Hong Kong SAR
Taiwan Province of China
Germany

Maximum index score is 1.

Table 2b. Index of Deflation Risk, with Latest Data (Equal Weight)1
Risk/
Index

1

Minimal< 0.2
Australia
CanadaChile
Denmark
FranceGreeceIreland
New ZealandRussiaSpain
United Kingdom
United States

Maximum index score is 1.

Low
0.2 ≤ x ≤ 0.3
Austria
Brazil
China
India
Italy
Korea
Malaysia
MexicoNetherlands
South Africa

Moderate
0.3 ≤ x ≤ 0.5
Belgium
FinlandGermany
NorwayPolandPortugal
Singapore
SwedenSwitzerland
Thailand

High
> 0.5
Japan
Hong Kong SAR
Taiwan Province of China

- 24 -

Table 3a. Index of Deflation Risk (1995) (Weighted)1
Risk/
Index

1

MinimalLow< 0.2
0.2 ≤ x ≤ 0.3
Australia
CanadaAustria
Denmark
Belgium
Italy
Chile
NorwayGermany
Singapore
GreeceUnited Kingdom
Hong Kong SAR
India
Ireland
Korea
Malaysia
New ZealandPortugal
South Africa
Taiwan Province of China
Thailand
United States

Moderate
0.3 ≤ x ≤ 0.5
FinlandFranceMexicoNetherlands
Spain
SwedenSwitzerland

High
> 0.5
Japan

Maximum index score is 1.

Table 3b. Index of Deflation Risks (1995) (Equal Weight)1
Risk/
Index

1

MinimalLow< 0.2
0.2 ≤ x ≤ 0.3
Australia
Chile
Austria
Germany
Belgium
GreeceCanadaItaly
Denmark
NorwayHong Kong SAR
Singapore
India
United Kingdom
Ireland
Korea
Malaysia
Netherlands
New ZealandPortugal
South Africa
Taiwan Province of China
Thailand
United States

Maximum index score is 1.

Moderate
0.3 ≤ x ≤ 0.5
FinlandFranceMexicoSpain
SwedenSwitzerland

High
> 0.5
Japan

- 25 -•

Some European economies have an increased vulnerability. In the euro area, risks
remain low in all the major countries, except for Germany. Were deflation to startin Germany and become sustained, pressures could spill-over into other euro area
countries fairly quickly, particularly through the financial system. However,considerable scope remains for easing monetary policy. Outside the euro area,
Switzerland appears to have a moderate risk, but also has scope for policy response.

55. Although these indicators present a mixed picture, they do not support strong concernsof generalized global deflation. With flexible exchange rates, global deflation is likely only ifthere were to be a series of significant shocks. This conclusion is reinforced by developmentsin the major economies:•

Corporate sector imbalances may be unwinding. Large corporate restructurings overthe past two years have also helped facilitate adjustment in balance sheets.

•

Labor incomes have continued to grow, offsetting a fall in household wealth. Labor
markets have so far been holding up better than during previous slowdowns,
particularly in the United States and euro area.

•

Policymakers still have some room to maneuver. There is substantial scope forlower rates in the euro area, and officials in most major economies have indicatedan awareness of risks.

56. This is not to deny the significant downside risks in specific economies. It is far fromclear that the full effects of the bursting of the equity price bubble have manifested
themselves. There are also concerns about the effects of a possible correction in house prices.
Furthermore, the expectations of a recovery, notably of investment, have been repeatedly
disappointed. This suggests that excess capacity may be larger than suggested by theavailable data, and the profit outlook cloudier than previously thought. In addition, in several
countries problems in the financial sector may be exacerbating risk aversion and provision of
credit.26
C. Deflationary Pressures in the Major Economies
57. This section assesses in more detail the risks of deflation in the largest industrial
economies. It augments the preceding analysis by presenting Phillips curve estimates of thechanges required in the output gap and the unemployment gap to set-off, or exacerbate,deflation. Taking the current estimates of the output gaps and the NAIRU as given, a26

For issues relating to investor risk appetite, see Kumar and Presaud (2002).

- 26 -

modified form of the Phillips curve was estimated for each of the G-7 economies.27 The
parameter estimates were then utilized to assess the likely output and unemployment gapsthat could lead to declines in the aggregate price levels, defined as either (i) mild deflation,
which would entail a modest decline in consumer prices for two to four quarters; or (ii)persistent deflation, which would involve at least four quarters of declines in consumer prices
by more than 1 percent. Detailed assessment of conjunctural developments and risks for theUnited States, Germany and Japan are provided in the attached Boxes.
United States
58. As suggested by the Indicators analysis, current risks of deflation in the United States
are low, but downside concerns remain because of weak activity. The underlying consumer
price inflation has slowed considerably in the past several years, with an increasing numberof industrial and service sectors experiencing price declines. Demand has been held back by
the effects of a sharp decline in equity prices, a rise in unemployment, and excess capacity inmany industries (see Box 4.1). The decline in equity markets to-date is similar to the decline
in Japan in the three years after the bursting of its asset price bubble (Chart 12a).
Nonetheless, strong productivity growth and tax cuts have helped support personal incomes,
and combined with mortgage refinancings have underpinned consumption. In addition, theunderlying rate of return in the economy appears to have held up fairly well, owing toaggressive corporate restructuring over the past two decades. Accordingly, inflation
expectations have been relatively stable, with the largest downside risks associated with thepossibility that consumption will slow before investment has a chance to rebound.
59. The Phillips curve estimates suggest that for mild deflation to take hold, the output gap
would need to increase by around 3 percentage points, to over 5 percent (Table 4). GDP
growth would have to remain around ¾ percent for the next five to six quarters, and theunemployment rate would need to increase from 6 percent (in 2002Q4), to 8 percent, within
4 quarters. For persistent deflation, the output gap would have to increase by over 5
percentage points, and the unemployment rate would have to move to 10 percent.
60. While there is a small risk that mild deflation could occur––the staff’s central
projection is for the output gap to widen in the first half of 2003––the expected policy
27

The estimated functional form was as follows:
π t = α 1 * π t −1 + α 2 * π t −2 + α 3 * π t −3 + α 4 * π t − 4 + β * U gap ,t + ϕ * (U gap ,t − U gap ,t −1 )where π denotes inflation and Ugap denotes the unemployment gap; equations for each of theG-7 economies were estimated over the period 1990 to 2001 using quarterly data; robustness
analysis was undertaken by estimating equations with varying sample size. A complementary
formulation utilized output gaps with the following specification:
π t = α 1 * π t −1 + α 2 * π t − 2 + α 3 * π t −3 + α 4 * π t − 4 + β * Ygap ,t + ϕ * (Ygap ,t − Ygap ,t −1 )where Ygap denotes the output gap. Both the output and employment gap data were obtained
from the OECD database and staff estimates.

- 27 -

response makes the likelihood of persistent deflation remote. Policymakers appear bothwilling and able to respond preemptively to the risk of renewed weakness and of deflation,even though the Fed Funds rate is at a very low level. For instance, Greenspan (2002) has
emphasized that it is crucial to “ensure that any latent deflationary pressures areappropriately addressed well before they become a problem” (see also, Bernanke, 2002 andReinhart, 2003a). Federal Reserve officials have also made public statements on themeasures they would consider to forestall deflation, including purchase of long dated
securities; and there is considerable fiscal stimulus in the pipeline and more on the horizon.
Moreover, should activity fail to rebound, the U.S. dollar could depreciate further, providing
a fillip to prices, exports and corporate profits.
Germany
61. With broadly stable prices over the past six months, the German economy faces
substantial demand driven drag to growth (Box 4.2).28 Credit growth, production, andincomes weakened considerably during 2001 and 2002, and the labor market has been
coming under pressure. House prices have been falling; equity markets have adjusted morethan in the other advanced economies (Charts 12a and 12b); and corporate balance sheet
adjustments still have some way to go. Furthermore, banks and insurance companies are, by
their own admission, undergoing the most challenging period since World War II. Thus thenear-term outlook for a recovery in investment remains more clouded than in the otheradvanced economies.
62. The Phillips curve analysis for Germany suggests that for mild deflation to take hold,the output gap would need to rise 1 to 2 percentage points (Table 4). At the same time, theunemployment gap would have to increase by 2 percentage points. For persistent deflation,
the output and employment gaps would have to increase by 2½ to 3½ percentage points. The
staff’s central projection sees a widening of the output gap on the order of 1 percentage point
this year because real GDP growth would remain around ½ percent. However, theunemployment rate would increase relatively modestly.
63. Accordingly, the probability of mild deflation taking hold over the next year is
considerable. Of course, as prices in Germany decline relative to its trading partners,
particularly in the euro area, the improvement in its competitiveness will stimulate exports
and investment. This may prevent expectations of falling prices from becoming entrenched.
However, this mechanism is likely to operate only slowly, and can do little to remedy
difficulties in financial intermediation that could develop rapidly in a deflationary
environment. Unlike in other economies, the room for policy maneuver is constrained, if notabsent altogether. Fiscal policy is set to become restrictive (cutting the cyclically adjusted
deficit by ¾ percent of GDP this year)––in support of Germany’s commitments under theMaastricht Treaty. While monetary conditions have tightened given the euro appreciation,
28

Prices have been broadly stable abstracting from one-off changes due to indirect taxes.

- 28 -

monetary policy may not ease significantly because of greater price pressures in Germany’s
euro-area partners.29
Japan
64. In Japan, core CPI deflation continued for forty-one consecutive months through March
2003, and there are only marginal signs of deflationary pressures waning. Unless policies
play a more supporting role and the economy’s long-standing structural problems areresolved, the risk of continued deflation remains high. In the near-term, with growth below
potential, the output gap is expected to widen further, potentially increasing downward
pressure on prices (Box 4.3). The Phillips curve analysis suggests that if the unemployment
gap were to increase by 1 percentage point, or the output gap by 2 percent the pace of
deflation would accelerate, which could heighten the risk of a deflationary spiral (Table 4).
65. An important issue relates to why deflation is not already worse given the continued
large output gap, high unemployment, and record business sector bankruptcies.30 This could
reflect in part sticky expectations. Both market and survey evidence suggests that deflation is
expected to remain around -½ to -1 percent. In the Consensus forecast, market participants
attach a 70 percent probability to deflation of around 0.8 percent in 2003. This expectation
may reflect a relatively flat Phillips curve; that is, the decline in activity and output gap
would have to be significantly greater than witnessed to-date for there to be a substantial
further increase in deflationary pressures. It is also possible that the monetary easing inrecent years has played a helpful role. The cumulative growth in base money has not been
aggressive enough to improve expectations, but it may well have played a role in preventing
deflationary expectations from worsening.
66. Nonetheless, despite the recent uptick, the economy is vulnerable to further adverse
shocks that could markedly worsen deflation. In particular, asset prices could come underfurther pressure if banking sector difficulties mount, and corporate de-leveraging continues.
In addition, investment could decline further in an uncertain environment.
67. Because of the risk that deflation could worsen, a more vigorous monetary-policy
response is needed even if structural impediments remain in place. Such an approach could
include a more rapid expansion of the monetary base in tandem with a commitment to end
deflation within a given time period. Backed up by a clear communications strategy, thesemeasures could reduce deflationary expectations (see Section V below).
29

Higher inflation in other euro area countries may of course help somewhat in restraining
deflationary pressures in Germany.
30

There is evidence that CPI understates deflation for reasons noted earlier. However, thatwould only mean that deflation is somewhat higher than currently measured, and not that it isgetting worse.

- 29 -

Other G-7 Countries
68. The pace of activity in France and Italy has slowed markedly in recent months, but therisk of deflation appears to be appreciably lower than in Germany. Despite the recent
downward revisions to projections, growth is projected to pick up in the second half of theyear in both France and Italy, confidence is somewhat better, house prices are continuing toincrease, and consumer prices are better sustained, with core inflation close to or higher than
2 percent.
69. In the United Kingdom and Canada, economic conditions do not raise immediateconcerns about deflation. Robust household demand growth has continued in the United
Kingdom—supported by a housing price boom, and GDP growth is expected to pick-up in
the second half of 2003 on the strength of public spending. Inflation and inflationary
expectations seem well supported. However, there may well be a risk of an abrupt correction
in house prices which could have a substantial adverse effect on domestic demand growth. In
Canada, although some recent indicators have been mixed, the underlying pace of growth
remains robust. For the second year in a row the economy is expected to attain the highest
growth rate among the G-7, and is the only one in the group to have virtually no output gap.
Inflation is well above the 2 percent target range.
70. The Phillips curve estimates for the above four countries suggest that the output andemployment gaps would need to increase substantially to move them into mild deflation.
These results complement the findings from the deflation vulnerability index, and suggestthat in these economies deflation risks are very small.

Table 4. Deflation Risk: Incremental Changes in Output and Unemployment Gaps1(in percent)Deflation Onset
Unemployment Gap Output Gap
United States
Germany
FranceUnited Kingdom
Italy
CanadaJapan

2 - 2½
1 - 1½>3
2 - 2½
5
5
---

3-4
1-2
4
2-3
5
>5
---

Persistent Deflation
Unemployment Gap Output Gap
3½ - 42½ - 3½
>5
2-3
>6
6
1

5-6
2 - 2½
>6
4
>5
>5
2

1. Estimates of the increase in the output and unemployment gaps likely to lead to the onset or persistence of deflation.

- 30 -

D. China
71. In China, the mild deflation is linked mostly to transitory as well as longer-term
supply-related factors. Transitory factors include lower commodity prices, WTO-related
tariff cuts, and restraint in administrative price increases stemming from social concerns.
Some of the longer-term factors include productivity gains from strong investment, stateowned enterprise (SOE) reform, and adoption of new technologies—supported by robust
increase in foreign direct investment—and stronger market orientation. A less benign
structural source of deflation is large excess capacity in some sectors, owing to the lossmaking operations of some state-owned enterprises. Large surplus labor in rural areas is also
acting to put downward pressure on costs and prices.
72. Risks of persistent deflation are small. Given the strong pace of activity, deflationarypressures should continue to ease over the course of this year as transitory factors fade (seeBox 4.4). Policies are also supportive; the monetary stance is accommodative, with room left
to maneuver, and fiscal policy has been expansionary. The recent depreciation of the U.S.
dollar has also led to an effective depreciation of the yuan. Expectations of continued strong
economic growth are reflected in buoyant private demand and increasing real estate prices.
However, some longer-term factors, including continued expansion in capacity and excess
labor could continue to press prices down and prevent Balassa-Samuelson effects from taking
hold. Further deflationary pressures arising from excess capacity could build if loss-making
operations of state-owned enterprises are not closed down in a timely manner. There is also arisk that if the SARS epidemic is not contained quickly, its adverse impact on private
spending could create deflationary pressures from the demand side.
China’s Trade Share and Transmission of Deflation
73. Supply-side factors in China are creating downward price pressures in a number ofindustrial sectors globally.31 Cheap and abundant labor and large production capacity havehelped China in the last 10 years gain market share in the United States and Japan. By 2002,
its share in total U.S. imports reached 11 percent, overtaking Japan as the largest exporter tothe United States; its share in total Japanese imports reached 18 percent during the same
period (Charts 13a-b). Although actual imports from China account for a small proportion of
consumption in most countries (in the U.S. imports from China account for 1 percent ofGDP), the potential imports appear to be a much larger. However, cheaper imports entail
terms of trade gains which, through their positive effects on aggregate income and demand
growth, could mute the direct deflationary effects in individual sectors.

31

In addition to light manufactures including clothing and textiles, and footwear, theseinclude an increasing range of high technology products, such as, digital cameras andcamcorders, televisions, electronic and personal computers.

- 31 -

74. Apart from the direct impact on prices, there may be an indirect impact through activity
on some competitor economies. The magnitude of the impact is illustrated by the increase in
China’s share in the Asian region’s total exports to the world from under 15 percent to close
to 30 percent over the last ten years. However, this change in market share is not fully at theexpense of other countries: there has been a sharp increase in intra-regional trade, with asignificant increase in imports by China from many of the regional economies which is likely
to help offset the adverse impact on activity and prices in these economies.32
75. Despite the increase in trade shares, there is insufficient evidence that China isexporting deflation, although there are marked price pressures in particular sectors. A Vector
Auto Regression (VAR) analysis on the linkage between prices in China and major trading
partners suggests that price fluctuations in China have a moderate impact in a few Asian
countries, and discernable but small impact on prices in the United States and Japan (Chart
14). In the region, prices in Taiwan Province of China and Hong Kong SAR are affected themost, owing to their strong links to mainland China, and the price changes appear to bepassed through fully in about 2 years. There is some evidence of transmission to Singapore,but in a more limited way. Prices in other economies in the region—Malaysia, Thailand,
India, and Indonesia—on the other hand, appear not to be affected at all by changes in prices
in China.
76. Nonetheless, the transmission effects appear to be growing over time. When a similar
VAR analysis is undertaken for the late1970s, the impulse response functions imply weakerlinks than the ones identified over 1993–2002. This change is not surprising because Chinese
external trade began to pick up around 1993, once the government initiatives to increase
exports started to take hold. Nonetheless, it does suggest that with the expected continued
integration of China into the global economy, the transmission effects could increase further.
V. POLICY RESPONSE
77. Given the costs of deflation, it is desirable to prevent it from taking root, rather thandeal with it once it has become entrenched. This is a particular challenge for policy in a low
inflation environment. A number of conceptual and practical issues related to both prevention
and cure are examined below. Strictly speaking, monetary policy should, by itself, be able tostave-off deflationary expectations. However, the central bank may underestimate the risks ofdeflation, or be unable to—because of political economy reasons—undertake the necessary
steps. When monetary response is insufficient or inadequate, fiscal policy and structural
measures can play an important role.
78. Policymakers need to be attentive to four channels through which deflationary forces
can be propelled and through which policy can act:
32

Indeed, over the past three years, the growth in total imports by China has outpaced thegrowth in its exports.

- 32 -••••

Exchange-rate channel: An open trading system can serve as a buffer, while fixedexchange rate systems have, in the past, transmitted deflationary shocks.
Asset price or portfolio rebalancing channel: Deflation affects the relative trade-off
between assets, and cash generates a risk free rate of return (equal to the rate ofdeflation), discouraging risk taking.
Expectations channel: Entrenched expectations help determine nominal wage
demands and ex ante real interest rates. Once deflationary expectations set in, they
help to drive up real wage costs and real interest rates.
Credit channel: When deflation reduces the value of collateral, banks find it
difficult to discriminate credit risks, and the external finance premium rises.
Distressed banks may curtail lending, further driving down output and prices.

79. A vigorous policy response may be required if one or more of these channels are notavailable. For example, if deflation is setting in, banks are restricting credit, and labormarkets are inflexible with sticky wages, the central bank may need to be particularly
aggressive in easing policy and changing expectations—so as to compensate for its reduced
ability to act through the other channels.
A. Policy Before the Onset of Deflation
80. Preventing deflation in a low inflation environment requires preemptive and possibly
aggressive action. Past episodes suggest that sustained deflation can be unanticipated, even as
inflation and nominal interest rates fall close to zero. The challenge is evident from the recent
experience of Japan. In the mid 1990s, household and business surveys—along withgovernment and corporate bond yields—showed that markets expected moderate inflation,right up to the onset of deflation. Furthermore, as Ahearne et. al (2002) show, ex ante, themonetary policy stance was appropriate or even loose (using Taylor-type monetary policyrule). But ex post, policy proved to be too tight, reflecting lower inflation than forecast.
Given such circumstances, with baseline forecasts still projecting inflation, policy makers
could be hard-pressed to justify implementing measures against deflation.
81. Monetary policy therefore needs to set targets to provide a buffer against the risks ofdeflation. Under inflation-targeting regimes, policymakers should not set an inflation target
that is too low, but instead provide a “buffer zone” to obtain insurance.33 As Figure 3
illustrates, the likelihood of hitting the zero bound on interest rates declines significantly as
the inflation target increases (see Box 5.1). With flexible monetary policy regimes, clear
communication with the markets is important, as is a willingness to act quickly,

33

A buffer zone is appealing because, as noted, inflation statistics suffer from measurement
issues and possible upward biases. The benefits of an inflation buffer zone must, of course,
be weighed against the costs of higher inflation rate in normal times (Bernanke, 2002).

- 33 -

Figure 3: Inflation Target and Zero Bound

Probabilityof Bind1
0.36
0.30
0.20
0.10
0

0.0

0.5

1.0

1.5

2.0

2.5

Inflation Target

Source: Hunt and Laxton (forthcoming).
1
Probability of zero bound on interest rates being hit with a given inflation target. These
probabilities are derived from Multimod simulations for a large open economy.

3.0

- 34 -

even though easing may appear unnecessary ex ante. Model simulations suggest that in Japan
lowering short-term interest rates by another 200 basis points at any point between 1991 andearly 1995 would have helped avoid deflation (Ahearne et al op. cit.). A proactive stance isparticularly necessary if financial markets and institutions may be in risk of coming understress, say following the bursting of an asset price bubble. Aggressive easing by the U.S.
Federal Reserve in early 2001 can be seen in this light.
82. Fiscal policy can play an important role in supporting incomes, relieving pressure on
firms’ and households’ balance sheets and underpinning confidence. In an environment of
deflationary expectations taking hold, and with the economy in a liquidity trap, stimulating
policy—beyond the automatic stabilizers—may be necessary. Measures to boost return on
capital investment that would have efficiency gains while signaling authorities’ commitment
to prevent a generalized decline in prices have an added attraction (see Rogoff 1998). In thecase of Japan, Ahearne, et al. (op. cit.) suggest that a moderate amount of additional fiscalloosening during the first half of 1990s could have assisted economic activity and lowered
the risk of deflation.
83. An open trading system offers a measure of protection from deflation, although thisprotection is much greater under flexible rather than fixed exchange rates. Countries with
deficient domestic demand face incipient downward pressure on tradable goods prices andinterest rates. With flexible exchange rates, and a liberal trade and capital account regime, thedownward pressure on interest rates would lead to currency depreciation and aid exports.
Under such circumstances, expectations of deflation are less likely to take hold. But policy
still needs to be alert to the risk of deflation spreading from imported deflationary impulses
in particular sectors, especially if the sectors are large with relatively inflexible structures.
Where exchange rates are fixed, including in a currency union, the adjustment to adverse
demand shocks would be considerably more protracted, as it would operate through domestic
prices rather than the exchange rate.34 This makes it more likely that expectations of deflation
develop, with further deleterious consequences for demand.
84. Lower barriers to trade can help in spreading the adjustment to demand shocks. Insteadof a large adjustment by a single country, a small adjustment globally could help to redress
country-specific imbalances.35 However, globalization may also contribute to raising thesymmetry of economic shocks across countries. The recent equity price bubble is an exampleof how increased financial linkages might contribute to spreading “irrational exuberance”
and a subsequent correction (see Rogoff et. al., 2003 on the costs and benefits of financial
globalization).
34

Meltzer (1999) argues that failure to allow the nominal exchange rate to depreciate has
forced deflation onto Japan.
35

From a multilateral perspective it might not be efficient to rely on this mechanism to exit
deflation, particularly for large countries. This issue is noted further below.

- 35 -

85. With flexible exchange rates, the threat of an internationally transmitted, global
deflationary shock is small. This is because countries in risk of deflation could expand theirmoney supply and create inflationary expectations. If the policy makers’ anti-inflation
credentials are high, there may be little risk that these expectations will be difficult toreverse. (This also underlines the case for the transparency in long-term objectives which
provide broad guidelines for inflation over the medium-term (Rogoff, 2003)). In the case of a
global demand shock, if every country expanded its money supply in response to a
deflationary impulse, exchange parities would change to the extent that the impact of theshock and the monetary response differed across countries. But in general the stock of money
would be higher, reducing the likelihood of deflationary expectations from gaining ground.
86. Nevertheless, the global effects of a depreciation in a large country can be significant.
A depreciation in the U.S. dollar, for example, would lead to higher U.S. exports, offsetting
foreign production, and put downward pressure on foreign prices. It would also have income
and balance sheet effects, and if the dollar decline were severe enough, foreign balance
sheets could come under significant pressure, aggravating deflationary pressures there witheffects that can rebound on the United States.36
B. Policy Once Deflation Has Set In
87. Policymakers face a difficult challenge under deflation, because the traditional
relationships between policy instruments and economic variables, as well as the transmission
mechanisms, may be impaired or altered. For example, when deflation has set in, even if
nominal rates are low or zero, monetary policy may not be loose enough to spur activity. Thismay be especially constraining given that in a liquidity trap, the economy’s equilibrium realinterest rate may well be negative.
88. The problems may be compounded if the banking system is undergoing difficulties, sayfollowing a sharp slowdown in activity or the bursting of an asset price bubble. An increasein banks’ bad debts is likely to reinforce their unwillingness to take risks, curtailing credit. In
such a situation, efforts to boost base money may have limited effect if the additionalliquidity largely ends up as banks’ excess reserves.
89. In these circumstances, historical experiences suggest that policymakers may need toconsider “unorthodox” policies. Monetary policy can generate inflation, independent of thestructural impediments in the economy (Rogoff, 1998 and 2002). As Bernanke (1995)
observes: “... if the price level were truly independent of money issuance, then the monetary
authorities could use the money they create to acquire indefinite quantities of goods andassets. This is manifestly impossible in equilibrium.”
36

See Reinhart (2003b) for a discussion of the spill-over effects of policy measures
implemented in a large economy. For some evidence on specific spill-over effects within theG-7 economies, see Kumar (2001).

- 36 -

90. For instance, the monetary authority, if credible, could lower interest rates along theyield curve by promising to hold short-term rates at zero for a specified period (along with an
explicit inflation target) or by purchasing longer-term bonds. The bond purchase operation
could be underpinned by announcing target yields and committing to purchase securities
consistent with that target, thereby lowering rates along the entire term structure.37 In
addition, the range of assets eligible as collateral for bank borrowing from the central bankcould be widened, reducing term and liquidity premiums and lowering the cost of capital.
The central bank could also extend its range of purchases to equities (exchange traded funds),
real estate (real estate investment trusts), or foreign assets (foreign currency or bonds).
91. Once deflationary expectations have taken hold, policies will be successful only to theextent that they manage to break expectations. Monetary policy helps to stimulate theeconomy because a lower policy rate helps to flatten the yield curve, lower long-term rates,and encourage contemporaneous consumption and investment. This role does not change
under deflation; the central bank must choose steps that have the largest effect on
expectations. For example, if the credit channel were not severely impaired, the central bank
may be able to lower long-term interest rates by purchasing government bonds along theyield curve, which would help encourage bank lending. However, if the credit channel wereimpaired or the balance sheets of firms and households were distressed, the central bank may
need to take more drastic steps, such as purchasing private assets.
92. The “unorthodox” policy prescriptions can pose operational challenges because thebroader impact of these policies may be uncertain. Even during inflationary times, the lag
structure and impact of changes in the monetary stance may be unclear. With unorthodox
policies, there may be little guidance to the appropriate extent of easing. There is also a riskthat the central bank’s balance sheet could incur sizeable capital losses if the value of theacquired assets falls. Nevertheless, these uncertainties and risks are small compared to thecosts associated with entrenched and deepening deflationary expectations. The monetary
policy response should also not be held hostage to structural reforms: one of the key lessonsof the events that led to the Great Depression in the U.S. was the misplaced and ultimately
catastrophic emphasis on reforms at the expense of monetary easing.38
93. Fiscal policy financed by monetary expansion can play an important role in thissituation. Indeed, for an economy in a liquidity trap, the use of unorthodox monetary37

For example, from 1942-51 the Federal Reserve successfully maintained a cap on Treasury
bond yields.
38

It is telling that in 1930 a key member of the U.S. Federal Reserve Board repeatedly
argued against aggressive quantitative easing. The official claimed that it would be
ineffective and most likely counterproductive; that the economy had to “pay” for theexcesses of the 1920s, and that the monetary easing would only interfere with the naturalprocess of restructuring (Goodfriend, 2001).

- 37 -

operations noted above could entail a significant fiscal element.39 Stimulatory fiscal policy
will boost activity, help address problems in the credit and asset channels, and result in an
increase in prices of goods and assets. For liquidity constrained consumers, traditional fiscal
multipliers may actually be higher under deflation than inflation because the credit channel is
weakened. If deflation is due to an especially large demand shock, beyond the automaticstabilizers, discretionary fiscal policy can play a particularly useful role in supporting
incomes and spending. A well-timed tax cut will increase disposable incomes, helping toencourage consumption. Higher government spending could also help boost production andrelieve unemployment. When banks are distressed and the credit channel is impaired, thegovernment may need to inject capital into the banking system, and under deflation, it may
need to act faster than it would otherwise.
94. However, fiscal policy needs to be tailored to credibly boost aggregate demand. The
stimulus should not be wasted on projects for political economy reasons that benefit too few
to have an effect at the aggregate level. Furthermore, to limit Ricardian effects, spending
programs and tax relief should target liquidity constrained consumers, and as noted above,projects that boost the return to private investment. It is also important to ensure that fiscal
policies do not give rise to a permanent increase in the level of expenditures. This suggeststhat measures to reallocate demand inter-temporally, for instance, through temporary tax
credits for investment or reductions in consumption taxes that automatically lapse after aperiod of time, would be most appropriate (see Feldstein, 2001 and 2002).
95. Structural reforms can also play an important role in combating deflation. By increasing
flexibility in factor markets, they may facilitate reallocation of resources. They may also
allow for a more rapid disposal of bad assets and promote enhanced intermediation in theeconomy, improving the effectiveness of the monetary transmission mechanism. In addition,measures aimed at promoting deeper and more liquid capital markets can help reduce
frictions generated by deflationary shocks; with the banking sector under stress, corporate
financing will be able to take place more readily if there is access to alternative markets. By
helping raise the long-term return on capital and enhancing the economy’s growth potential,
structural reforms can thus be a key component of an anti-deflation strategy. Even in the
short-run, a credible and well-articulated package of reforms can underpin confidence and byraising expectations of future growth mute deflationary pressures. Structural reforms should
not, however, be regarded as a prerequisite for the monetary and fiscal response.

39

See Buiter (2003) who also suggests that conventional monetary policy alone may curedeflation when used to monetize (in secondary markets if institutional constraints exist)
expansionary fiscal policy.

- 38 -

Box 4.1:United States—Economic Outlook and Deflation Risks
With strong financial headwinds from a large accumulation of debt during the late 1990s and a sharp
decline in the U.S. equity markets, some observers have wondered if the United States could experience
deflation. A few months of negative headline CPI inflation cannot be ruled out, but the likelihood ofsustained deflation appears remote.
Aggregate Demand and the Output Gap: While there is uncertainty about the degree of excess
capacity, the acceleration in productivity after 1995 means that the potential growth rate is substantiallyabove recent growth, leading to a widening output gap of just over 2½ percent in 2003q1, anddisinflationary forces. Domestic demand in the past two years has been buffeted by a series of shocks,
including continuing equity price declines, accounting scandals, September 11th attacks, the war in Iraq
and broader geopolitical uncertainties. Consumption continued to grow, in part supported by house priceincreases, but the need to rebuild wealth could cause the saving rate to rise sharply, curtailingconsumption. Weaker labor markets and the waning effects of tax cuts could exacerbate the effects on
consumption. The recovery in investment has yet to become broad-based and firmly established.
Nonetheless, with strong support from monetary and fiscal policies, and continuing impressive
productivity performance, GDP growth is expected to begin strengthening in the latter half of 2003. The
recent data on corporate earnings have been encouraging, and there are indications that consumer andbusiness confidence may be recovering.
Prices: Corporate prices have fallen much more than consumer prices, cutting into corporate
profits, but economy-wide aggregate price levels do not show signs of declining. Core CPI is down
to 1¾ percent (y/y) in March 2003 (compared to 2¾ percent during 2001 and 2 percent during 2002),
with headline inflation rising to around 3 percent. The GDP deflator is around 2 percent (yoy), and the
deflator for the nonbusiness sector has fallen sharply (Figure 1). However, given the policy stimulus in
the pipeline and the expected pick-up in activity, inflation expectations—as measured by surveys andspreads on inflation-indexed bonds—have been relatively stable.
Corporate Sector: With a sharp fall in industrial output, the U.S. corporate sector led the economy
into recession. Industrial production declined 6 percent during 2001; at the depth of the recession in
2001, GDP declined only ½ percent. When corporate profits came under pressure, firms embarked on an
ambitious cost-cutting strategy, sharply reducing investment (Figure 2). While some have worried aboutovercapacity, rates of return on capital have held up, indicating that firms do not yet have difficultyusing their capital stock efficiently.
Monetary and Credit Conditions: Bank lending ground to a halt in early 2002, but it did notcontract (on a y/y basis), and banks remain relatively healthy. Credit growth has subsequently
recovered, and by March 2003 was growing by around 7 ½ percent (yoy). Corporate credit spreads, after
widening in late 2001 and early 2002 reflecting Enron and other corporate accounting concerns, haverecently narrowed.
Asset Prices: U.S. equity markets peaked in March 2000, and at the height of the technology
bubble, household wealth peaked near $43½ trillion, or 6.3 times disposable income (Figure 3).
Since then, net worth has fallen $4 ¼ trillion to 4.9 times disposable income. Normally, such a large
decline would have sparked a significant decline in consumption, but well-timed tax cuts in 2001
cushioned the blow by helping to support disposable incomes. The housing market has responded toaggressive interest rate cuts, and housing wealth rose $1½ trillion during 2000-2002.

- 39 -

Box 4.1: United States—Economic Outlook and Deflation Risks (cont.)
Policies: U.S. policy makers have shown remarkable flexibility in responding to the economic
shocks, and the central bank appears ready to use unorthodox policy measures to prevent
deflation. Monetary policy remains accommodative, and recent indications by Federal Reserve
governors seem to be preparing the markets for unorthodox monetary policy if the target federal funds isnear zero (Bernanke, 2002 and Greenspan, 2002). Fiscal surpluses achieved during the late 1990s haveturned into deficits, but the stock of government debt is forecast to remain stable at under 40 percent of
GDP for the remainder of the decade, leaving room for stimulus, if necessary.

Figure 1. Inflation (y/y percent changes)
4

10

Figure 2. Corporate Costs, Spending, and Borrowing (y/ypercent change)
Unit labor
costs

5
3

40
20

CPI
0

0
Fixed invest.
2

1

-10

-60
-80

-20

1995 1996 1997 1998 1999 2000 2001 2002 2003

2000

Figure 3. Household Saving and
Net worth (as share of DPI)
8

0

7

100
Saving rate

200

5

300

4

400

3

500

2

-40

Corp.
Borrow.

-15

0

6

-20

-5
Non-farm,
non-house
Deflator

Net Worth

600

1

700

0

800

1995 1996 1997 1998 1999 2000 2001 2002 2003

2001

2002

2003

- 40 -

Box 4.2: Deflationary Pressures in Germany
Many indicators suggest that deflationary forces are at work in Germany: (i) underlying inflation isrunning under 1 percent per annum; (ii) unit labor costs (ULCs) for the entire economy have grown at an
average rate of about ¾ percent in the past five years; (iii) equity prices have retreated by about 40 percent
during 2002, to levels last seen since early 1997––the evidence on real estate prices is mixed, with some
(BIS) indicators suggesting that prices have retreated over the past decade and others (CPI rent component)
pointing to stability; (iv) real domestic demand is contracting and GDP growth will fall well short ofpotential for the third year running in 2003, causing a widening of the output gap to nearly 2¾ percent ofpotential GDP; (v) the number of bankruptcies is reaching record levels and (vi) domestic credit almost
ground to halt in mid-2002, as German banks are struggling to maintain their regulatory capital, while
suffering asset price declines and loan losses.
Although the near-term outlook for the German economy is fairly bleak, most forecasters do notforesee a significant decline in inflation for 2003: the consensus forecast for 2003 is for 1.2 percent, with
one half of observers seeing a decline in inflation relative to 2002. However, the task force’s analysis
suggests that mild deflation is fairly likely to take hold even though the risks of pernicious deflation are low.
First, the estimated output gap is large and the (ILO) unemployment rate remains high––at some 7.7 percent
in 2002Q4––even if it is down from a peak of 9.3 percent in 1997. Balance sheet indicators for the ratio ofafter-tax profits to turnover display no structural decline but are likely to have taken a blow over the past two
years; and OECD data for the business sector suggest that the capital-output ratio in 2001 still exceeded thepost-1980s average by 2 percent, down from a peak excess of 4.3 percent in 1996. Notice that the size of theoutput gap is not unprecedented: it compares to that of 1982-84. However, during the early 1980s theunemployment rate and the capital-output ratio were lower and inflatiornary pressures higher.
Second, credit growth is low and bank profitability weak––owing to deteriorating asset markets, highcompetition, and a cost structure that does not compare favorably even against those in other continental
European countries.. Credit growth has fallen short of demand, as measured by a linear combination of GDP
and interest rates, but the shortfall compares to that seen in earlier recessions. While a case for a credit
crunch is hard to make at this stage, banks are facing, by their own admission, the most difficult businessenvironment since World War II, suggesting that financial intermediation is unusually vulnerable to adverse
shocks.
Third, although the external sector is serving as a floor on prices and output, that floor is unlikely to buffer
the effects on GDP of a sudden, rapid deterioration in domestic demand. Germany has become morecompetitive, seeing its external current account balance improve from a deficit of about ½-1 percent of GDP
during the 1990s, to an estimated surplus of 2 ½ percent of GDP in 2002, a level last reached just before
unification. According to some estimates, a 2 percent of GDP surplus is in line with equilibrium estimates ofGermany’s current account (Figure) and thus the potential for saving rates to rise has diminished. However,
because the improvement in the external position was achieved largely through slow import and domestic
demand growth––rather than higher productivity and export growth, as had been hoped following
unification––downside risks remain.

- 41 Box 4.2: Deflationary Pressures in Germany (cont.)
Lastly, but perhaps most importantly, a major concern for Germany is the constraint on macroeconomic policies: monetary
policy is geared to the euro area where price pressures are not considered to have subsided sufficiently. And Germany’s fiscal polic
is widely seen as turning highly contractionary in the near-term, to move the fiscal deficit back under the 3 percent Maastricht
reference ratio. The automatic stabilizers, which––together with the ECB commitment to price stability––could offer some
protection against sustained deflation, are thus not allowed to widen the fiscal deficit while growth continues to fall short ofpotential.
Private sector credit and CPI index
10

Debt Burden
3.5(6-month change in percent, annualized)

40

3

8

2

1

2

120.0
100.0
80.0

25

60.0

0.5
private sector credit

0

1996

1997

1998

1999

20

0

CPI index excluding energy and food(right scale)

-2

2000

-0.5
-1
2001

Interest-Profit Ratio

40.0

Debt-Equity Ratio (right axis)

20.0
0.0

15
1991

2002

1993

1995

1997

1999

2001

Source: Deutsche Bundesbank, and staff calculations.

Source: Deutsche Bundesbank, and staff calculations.

Profits over Turnover
2.5

140.0

30

1.5

4

160.0

35

2.5

6

180.0

(In percent)Model Projections of Credit Growth 1/
2.0(In percent; west Germany, unless solid line)

3.5
3.0

2.0

1.5

1.5

1.0

New
definition
1.0

4.0

( Quarterly rate of growth, in percent)Actual Credit GrowthFitted Demand Model 1/

2.5

2.0
1.5

1.0

1.0

0.5
0.5

0.0

1980

1984

1988

1992

1996

2000

Source: Deutsche Bundesbank, and staff calculations. Data break in
1994.

Real Effective Exchange Rates Against
19 Industrial Countries

3.0
2.5

2.0
1.5

0.5

3.5

0.5

0.0

0.0

1990Q3

1992Q3

1994Q3

1996Q3

1998Q3

2000Q3

Source: Deutsche Bundesbank; and staff calculations (see Germany:
Selected Issues, 2002)
1/ In-sample forecast after 1999.

SI Norm and Underlying CurrentAccount
120

6

115

5

110

110

4

105

105

3

100

100

2

2

95

95

1

1

90

90

0

0

-1

-1

-2

-2

120
115

85
80
75

(Actual REER vs linear time trend)

CPI-based
CPI-based trend
Unit labor cost-based
Unit labor cost-based trend

70

85
80
75
70

1988Q1 1990Q1 1992Q1 1994Q1 1996Q1 1998Q1 2000Q1 2002Q1

Source: Deutsche Bundesbank, and staff calculations.

6(In percent of GDP)

5

Underlying Current Account
SI Norm
Current Account (actual)

-3

4
3

-3
1988

1990

1992

1994

1996

1998

2000

Sources: IMF, World Economic Outlook; and staff calculations (seeGermany: Selected issues, 2002).

- 42 -

Box 4.3: Deflation in Japan
Japan’s experience with low inflation is hardly recent. In the fifteen years prior to the onset of deflation in
the mid-1990s, its annual core inflation (CPI excluding fresh food, and energy) averaged 2.1 percent. During
the mid-1980s, core inflation fell close to zero, followed by several quarters of decline in the GDP deflator.
As growth picked up sharply from late-1987 onward, coinciding with a tremendous run-up in land and equity
prices, the economy overheated, operating at 2-3 percentage points over potential GDP in the late-1980s andearly-1990s, but CPI rose only moderately. Core inflation peaked at slightly above 3 percent in early 1991,
and then began trending down, with a tightening of monetary policy, and a collapse of asset prices. Bernanke
and Gertler (2001) argue that the Bank of Japan (BoJ) was behind the curve during this boom-bust cycle—
the central bank waited too long before tightening monetary policy during the bubble period, and delayed ineasing once the economy headed downward.
The sharp fall in land and equity prices was followed by real GDP growth coming to a crawl. A
widening output gap, reflected in the sizeable excess capacity in the manufacturing and construction sectors,
exerted further downward pressure on prices. Banks, which had leant heavily to real estate and construction
companies, struggled under a mountain of bad loans and rapidly declining profitability. They focused on
consolidating their balance sheets and sharply curtailed further credit. Reflecting the loss of economic
momentum, broad money (M2+CDs) growth declined rapidly, from over 11 percent in 1990, to 0.6 percent
in 1992.
With declining activity, inflationary pressures virtually dissipated. Additionally, prices in the tradable
sector were affected by the further opening of the economy and the resulting competitive pressures.1 Prices
in the non-tradable sector also faced some downward pressures owing to deregulation and innovations. In its
efforts to stimulate demand and prices, the BoJ eased monetary policy, lowering the uncollateralized
overnight call rate from 8.5 percent in early-1991 to 0.5 percent by late-1995, but that proved to be
insufficient in the face of an unrelenting decline in asset prices and resulting problems.
The GDP deflator began its near-continuous decline in 1995 and Core-CPI deflation materialized fully
in 1998 with the onset of a recession. A short-lived economic recovery around the Y2K-related investment
boom in the late-1990s did little to arrest deflation. Initiatives to recover the economy fell short, andconsumption and investment remained weak. As a result, asset prices continued to decline, with both landand equity prices near two-decade lows at end-2002. Inflation expectations, which remained positive until
the beginning of actual price declines, subsequently turned negative and became entrenched as a sustainableeconomic recovery proved to be elusive. Surveys indicated that households and firms expected prices tocontinue to fall in the foreseeable future. The BoJ responded by gradually lowering the overnight call rate
toward its floor in the late-1990s, but base money growth rates remained relatively muted until early-2001. A
quantitative easing framework was then put in place, with banks’ excess reserves held at the BoJ becoming
the operating target. The BoJ incrementally raised its target of purchasing government bonds as part of thequantitative easing policy, but so far there is little evidence that its actions have been sufficiently aggressive
to dent deflationary pressures.
The ongoing deflationary episode has been strikingly broad-based in its nature. Very few items in the
consumer price index have experienced increases or even price stability. Prices of major items such as food,clothing and footwear, furniture, transportation and communication, housing rent, and durable goods, have
all registered gradual declines. The general decline in price levels cannot be explained a single factor, such ascompetitive pressure from abroad or excess capacity and deregulation at home. Rather, a combination ofthese and other factors, including banking sector difficulties, insufficiently loose monetary policy, andstagnant demand have been instrumental.
1

Kamada and Hirakata (2002), estimating a comparative advantage model for Japan, show that some of the downward
pressure faced by consumer prices in the mid- and late-1990s can be explained by the increase in international
competition.

- 43 -

Box 4.3: Deflation in Japan (cont.)
On the policy front, clearly, an aggressive easing of monetary policy is essential in combating
deflationary pressures. Studies of historical episodes of deflation have repeatedly shown that a large andsustained increase in liquidity is a prerequisite to generating inflationary expectations, and despite recent
measures such as targeting banks’ excess reserves held at the BoJ, Japan’s monetary policy has not been
sufficiently loose (Baig, 2003). Additionally, a comprehensive approach to tackle the bank and corporate
sector problems is needed to stimulate demand and prices on a sustainable basis and bring the economy outof its protracted stagnation.
Figure 1. Japan: Selected Economic Indicators, 1980-2002
Twelve-month percent change
66Core Inflation 1/

4

4

Four-quarter percent change
20

20

15

15

10

10

5

5
0

Real GDP and Industrial Production Growth

2

2

0

0

0

-10

-5

-5

-15
-2

-2
81

84

87

90

93

96

99

-10

Real GDP
Industrial production

-15
-20

-20

02

80

82

84

86

88

90

92

94

96

98

00

02

In percent
8

8

1980=100
600

600

6

6

500

500

4

4

400

400

2

2
300

300

0

0
200

200

Output Gap and GDP Deflator-2-2

Output Gap, as a percentage ofpotential GDP
GDP Deflator, year-on-year growth
rate

-4
-6
80

82

84

86

88

90

92

94

96

98

00

-4
-6

35

35
30

Overnight call rate (percent)
Monetary base
Bank lending

25

25

20

20

15

15

10

10

5

5

0

0

-5

-5

-10

-10
80

82

84

86

88

90

92

94

96

98

00

100
0

0
80

40

Money and Credit Growth

NIKKEI 225
Land price index

100

02

Twelve-month percent change
40

30

Asset Prices

83

86

89

92

95

98

01

1990=100
180

180

160

160

140

140

120

120

Real Effective Exchange Rates

100

100
CPI based
Unit labor cost based

80

80
60

60

02

80

82

84

86

88

90

92

94

96

98

00

02

Sources: IMF, Information Notice System; CEIC database; and staff estimates.
1/ Excludes fresh food, fuel, water and light; seasonally adjusted. The two spikes around 1989 and 1997 are due the introduction and subsequent
increase of consumption tax.

- 44 -

Box 4.4: China—Recent Deflation Episodes
Prices: The recent deflation episode is the second in the last four years. After peaking at over 25 percent in
1994, CPI inflation declined steadily as macroeconomic policies were tightened to cool the overheatedeconomy. Prices began to fall in 1998 as the economy slowed further in the wake of the Asian crisis, and thislasted until 2000. Deflation resurfaced during late 2001– end-2002, peaking in April 2002 at 1.3 percent. Falling
goods prices more than accounted for this decline, as most service prices continued to increase moderately.
During the same period, PPI declined also, with PPI deflation exceeding 4 percent in early 2002, but thisdecline ended by December 2002.
Staff analysis suggests that in the second deflationary episode, both transitory and longer-term supply
shocks were at play. In the short-run, lower commodity prices and WTO-related tariff cuts put downward
pressure on prices, and led to a mild deflation. Longer-term factors include: productivity gains from reforms toState-Owned Enterprises (SOEs), adoption of new technologies, and greater competition from more open
markets. Among the less benign factors is high excess capacity in some sectors owing to difficulties in closing
some SOEs.
Monetary and Credit Conditions: Strong foreign exchange inflows pushed the M2 growth rate to 18 ½
percent (year-on-year) in the first quarter of 2003. While overall lending was strong, lending by large state
commercial banks remained cautious.
Policy Impediments: Despite improvements, shortcomings remain in China’s institutional framework,
which reduce the effectiveness of indirect monetary instruments, and China faces medium-term fiscalpressures. Monetary policy faces significant headwinds from an underdeveloped interbank market.
Furthermore, while fiscal policy was geared to support domestic demand in 2002, fiscal consolidation is neededin the medium term, in view of the large quasi-fiscal liabilities in the banking system and future costs of pension
reform, infrastructure, and other social needs.
10

10
8

Inflation(12-month percent change)

8

10
8

10

Components of inflation(12-month percent change)

8

CPI

6

6
4

PPI

CPI

4

4

2

2

0

0

-2

-2

-6

-4

-4

-8

-6
1997

2

0

0

-2

-2

-4

-4

-6

1998

6

Non-food price index

4

2

-8
1997

Food price index

6

1999

2000

2001

2002

2003

-6
1998

1999

2000

2001

2002

2003

- 45 -

Box 5.1: Inflation Targeting and Deflation Risks
The benefits of low inflation are well known. But given risks of deflation, is there a case for targetinga somewhat higher rate of inflation, say 2 to 3 percent, rather than a lower or zero rate? There are three
relevant considerations:First, a small positive rate would reduce the likelihood that countercyclical monetary policy
becomes constrained by the zero floor on nominal interest rates. A number of studies suggest thatthe probability of the zero interest rate floor becoming binding is small for inflation targets down toaround 2 percent, but then increases for lower targets, and especially below 1 percent (see Hunt andLaxton 2003, Kieler 2003, Reifschneider and Williams, 2000 and Yates 2002). It has been argued thatthese findings may underestimate the likelihood of the zero constraint becoming binding given the nonlinearities in the system.
Second, the potential dispersion in trend inflation across members of a currency union may belarge. Inflation in some countries may have to be compensated for with deflation in others, if theinflation target for the union is low. For the Balassa-Samuelson effects, a variety of studies suggest thatthe steady state inflation in Germany could be significantly below the euro area average, and perhaps
below 1 percent if the ECB aims for 1.5 percent for the aggregate.1
Third, inflation may facilitate relative price and wage adjustments in an economy where agentsare averse to nominal wage or price cuts.2 Downward rigidities may stem from elements of money
illusion, and employer concerns about the impact of wage cuts on worker morale. Akerlof et al. (1996)
argue that steady-state unemployment in the United States would be considerably higher at rates ofinflation below 3 percent, and especially below 2 percent. However, the coexistence of low inflation andfalling NAIRUs in a number of industrialized economies in the 1990s—including the United States andthe United Kingdom, and several euro countries—suggests that the reduction in inflation to roughly
2 percent has not had any detrimental impact on the smooth functioning of labor markets.

1

See for example, Canzonieri and others (2002), and De Grauwe (2000). The Balassa-Samuelson model
has not received unequivocal backing in the empirical literature. For example, Rogoff (1996) concludes
that across industrialized countries, there is long-run convergence to PPP, the Balassa-Samuelson effectnotwithstanding. Kieler (2003) shows how average inflation rates might differ across the euro-areacountries over the long-run depending on the how fast remaining differences in price levels are reduced.
The results suggest that trend inflation rates could vary from around 1-1¼ percent in Germany andFrance to 2-3¼ percent in Portugal, Greece, and Spain, assuming an inflation target of 1.5 percent.
2

See Keynes (1936); Tobin and Dolde (1971).

- 46 -

APPENDIX I

Index of Deflation Vulnerability-- Data Sources and Definition of Variables
1.
Most of the data were drawn from two main sources: Haver Analytics’ EMERGE
database (for emerging market economies) and the OECD’s Main Economic Indicators
database (for OECD members). The Haver data are derived from national sources, and someattempt is made to harmonize data types across countries. The OECD data are highfrequency data (many series are available on a monthly basis). The remaining data are fromthe IMF’s International Financial Statistics (IFS) and WEO and Global Data Source
databases.
2.
In all, 14 measures of deflationary pressure were compiled for each of the 35
economies, at least from 1994 to 2002 (or until the latest possible observation). Each measure
was a binary (1/0) indicator, with a “1” reflecting possible deflationary pressure from thatsource.
3.
Prices (3 measures). Each measure of inflation scored a 1 if the rate for that quarter wasless than 1/2 percent. Inflation was measured as a Q4/Q4 change in the price index (for CPI
and core CPI) or GDP price deflator. Quarterly CPI inflation data are available for all 35
countries from the IFS database. GDP price deflators are derived from the ratio of nominal
GDP (from IFS) to real GDP (from WEO and IFS). Because some emerging markets did notreport core CPI to the IFS, it had to be supplemented using data from Haver, where available.
4.
Output Gaps (3 measures). The following measures of excess capacity and weak
demand were used: (i) whether the output gap had increased by more than 2 percentage
points over the past 4 quarters; (ii) whether the current output gap was more than 2 percent;(iii) whether real GDP growth over the past three years was less than the annual average
growth over the preceding decade. Output gap data were available only for 21 countries(mostly industrial), provided by IMF desk economists. For the remaining 14 economies, a
Hodrick-Prescott filter was used to create potential output data. While the smoothed
approximation to potential GDP is not perfect, the estimates seemed to match recent demandand supply pressures. Using the Hodrick-Prescott filter for the industrial economies (where
the output gap data are available directly) does not change the results.
5.
Stock Market Prices (1 measure). To measure pressures on the asset markets, thisindicator measured the change in the broad measure of the stock market over the past three
years (that is, the change over the past 36 months). The stock price index data were available
in Datastream and were roughly comparable to the coverage of the U.S. S&P 500.
6.
Exchange Rates (1 measure). The exchange rate measure scored a 1 if the real,effective exchange rate (REER) had appreciated by more than 4 percent on a Q4/Q4 basis—
measuring downward price pressures from the external sector. The REER was available from
JPMorgan for all economies, except Poland, Russia, and China. JPMorgan’s index is notavailable for those countries because its base year is 1990=100. For those three countries, the
REER was taken from IFS.

- 47 -

APPENDIX I

7.
Private, Nominal Credit Growth (Total Lending to the Private Sector, 2 measures). The
following two measures of a breakdown of credit allocation were used: (i) whether Q4/Q4
credit growth was less than Q4/Q4 nominal GDP growth; and (ii) whether cumulative credit
growth over the past three years was less than 10 percent. Credit growth was only measured
by the nominal value of credit (or lending) to the private sector, and the growth rate wasmeasured on a year-on-year basis. The private credit data were, unfortunately, not available
on a consistent basis across all countries. For most (13) emerging market economies, the only
data available were from the IFS (line 32d.ZF..., Claims on the Private Sector). For mostindustrial economies, private sector credit data were available from the OECD’s MEI
database (Australia, Austria, Denmark, Finland, Greece, Ireland, Italy, New Zealand,
Norway, Poland, Sweden, and Switzerland). Data for the remaining euro area economies
came from national authorities. Data for the G-7 economies came from a combination ofHaver data and national authorities.
8.
Money Supply Growth (1 measure). The money growth measure scored a 1 if broadmoney growth on a y/y basis grew slower than base money by two percentage points (or less)over the past eight quarters, to capture the relative efficacy of the monetary transmission
mechanism. Money supply data were available for all emerging market economies, except
China and Russia. For the remaining non-euro area economies, we used the national
authorities’ definitions of broad money (where available) in the Haver database. When thedata were not strictly identified as broad money, we used M3 (or M2 in the rare cases where
M3 was not available). For base money, we used the value of currency in circulation as ameasure of base money, and if that was not available, we used M0. For the euro-area
economies, it is technically possible to measure money supply growth, because the national
authorities compute the national contribution to euro area money supply. However, we
decided to exclude the euro area economies from this measure.
9.
Data Aggregation and Weighting. For the weighting procedure, countries were divided
into three cohorts on the basis of the ratio of equity market capitalization to GDP. Countries
that have a relatively large equity market were given greater weight. A similar scheme wasused to reflect the heterogeneity in the financial sector, using the stock of outstanding private
credit relative to GDP as an indicator to divide countries into three corresponding cohorts.
10. A country that was in the top cohort in either category received a weight of 3 on thatscore, a country in the middle cohort received a weight of 2, and an economy in the bottomcohort, 1. As an example, if in an economy equity market declined by at least 30 percent andits market size was in the top cohort, it received a score of 3. In this example with 11
indicators, and weight adjustment, an economy in the top cohort for equity market size with a
30 percent decline thus receives a value of 0.23 (3/13) in the index, whereas a country in thethird cohort and the requisite decline would receive a score of 0.09 (1/11).

- 48A Chart 1a. CPI and GDP Deflator in G-7(percent change from a year earlier)CPI
GDP Deflator
10
8

10

G-7

8

6

6

4

4

2

2

0

0

-2
1985

1990

1995

2000

-2
1985

Canada

8

6

6

4

4

2

2

0

0

-2
1985

1990

1995

2000

10
8

10

Germany

8
6

4

4

2

2

0

0

1990

1995

2000

10
8

2000

1990

1995

2000

1990

1995

2000

1990

1995

2000

France

-2
1985

10

United Kingdom

8

6

6

4

4

2

2

0

0

-2
1985

1995

Japan

-2
1985

6

-2
1985

1990

10

10
8

United States

1990

1995

2000

-2
1985

Italy

- 48B Chart 1b. CPI and GDP Deflator in Other Advanced Economies(percent change from a year earlier)CPI
GDP Deflator
10
8

10

Other Advanced Economies

8

6

6

4

4

2

2

0

0

-2
1985

1990

1995

2000

10

10
8

-2
1985

Netherlands

6

4

4

2

2

0

0

1990

1995

2000

10
8

-2
1985

10

Denmark

8

6

6

4

4

2

2

0

0

-2
1985

1990

1995

2000

10
8

-2
1985

10

Switzerland

8

6

6

4

4

2

2

0

0

-2
1985

1990

1990

1995

2000

1995

2000

1995

2000

Sweden

8

6

-2
1985

Spain

1995

2000

-2
1985

1990

Ireland1990

Norway(16.0)

1990

1995

2000

- 48C Chart 1c. CPI and GDP Deflator in Asian Economies(percent change from a year earlier)CPI
GDP Deflator
25
20

25

Developing Asia

15

15

10

10

5

5

0

0

-5
1985

1990

China

20

1995

2000

18

-5
1985

1995

2000

1990

1995

2000

18

Korea

India

12

12

6

6

0

0

-6
1985

1990

-6
1990

1995

2000

1985

18

18

Taiwan Province of China

Hong Kong SAR
12

12

6

6

0

0

(-6.2)
-6
1985

1990

1995

2000

18

-6
1985

1995

2000

1995

2000

18

ThailandSingapore
12

12

6

6

0

0

-6
1985

1990

-6
1990

1995

2000

1985

1990

- 48D Chart 1d. CPI and GDP Deflator in other Emerging Market Economies(percent change from a year earlier)CPI
GDP Deflator

32
28
24

32

Latin America

28

20

20

16
12

16

8

8

4
0

4

-4
1996

-4
1996

12

0

1997

1998

1999

2000

2001

2002

2003

32
28

28
24

20

20

16

16

12

12

8

8

4

4

0

0

-4

-4

80

1997

1998

1999

2000

2001

2002

2003

Central and Eastern Europe

80

Russia

40

40

20

20

1997

1998

1999

2000

2001

2002

2003

30

0
1996

2000

2001

2002

2003

1997

1998

1999

2000

2001

2002

2003

1998

1999

2000

2001

2002

2003

1999

2000

2001

2002

2003

30

Hungary

25

20

20

15

15

10

10

5

5

0
1996

1999

Mexico

1997

60

25

1998

1996

60

0
1996

1997

32

Brazil24

1996

Argentina

24

1997

1998

1999

2000

2001

2002

2003

0
1996

Poland1997

1998

- 49A Chart 2a. Goods Prices(percent change from a year earlier)

8

8

6

Canada42

0

0

United States

-2
-4
1996

Germany
1997

1998

1999

2000

2001

2002

-4
1996

1997

1998

1999

2000

2001

2002

30

South
Korea

20
10

20

Singapore

10

Thailand

Poland

0

0

-20
1996

France

-2

30

-10

Italy

4

UnitedKingdom

2

6

TaiwanProvince of
China
1997

1998

1999

-10

2000

2001

2002

-20
1996

Czech
Republic

1997

1998

1999

2000

2001

2002

- 49B Chart 2b. Producer Prices(percent change from a year earlier)

12

Canada108

United States

6
4
2
0
-2
-4
1991

1993

1995

1997

1999

2001

2003

1999

2001

2003

1999

2001

2003

12
10
8
6
4

Japan

2
0
-2
-4
1991

1993

1995

1997

12
10
8
6

Italy

UnitedKingdom

420-2France

-4
1991

1993

Germany
1995

1997

- 50 Chart 3. Average Inflation Rates (CPI)(in percent)Industrial Economies
10
9
8
7
6
5
4
3
2
1
0
1950-59

1960-69

1970-79

1980-89

1990-99

2000-03

Developing Economies
10
9
8
7
6
5
4
3
2
1
0
1970-79

1980-89

1990-99

2000-03

- 51 Chart 4. Consumer Prices and Inflation: United States and United Kingdom (1801-2002)

Consumer Price Index (Log Scale) 1967 = 100
600
6.4
6
400
5.3
200
4.6
100

United States

3.9
50

20
3
United Kingdom

1.65

1801

1821

1841

1861

1881

1901

1921

1941

1961

1981

2001

Consumer Price Index (percent change from a year earlier)30

United States
20

United Kingdom

10

0

-10

-20

-30

1801

1821

1841

1861

1881

1901

1921

1941

1961

1981

2001

- 52 Chart 5. Yield Differential Between Nominal and Index-Linked Government Bonds(basis points)

350

350

United States (10-year)

300

300

250

250

200

200

150

150

100

100

50

50

0
1998

350

1999

2000

2001

2002

2003

0
1998

350

Canada (30-year)

300

300

250

250

200

200

150

150

100

100

50

50

0
1998

350

1999

2000

2001

2002

2003

2001

2002

2003

Australia (10-year)

300
250
200
150
100
50
0
1998

1999

2000

0
1998

United Kingdom (30-year)

1999

2000

2001

2002

2003

2001

2002

2003

France (10-year)

1999

2000

- 53 Chart 6. Commodity Prices

a. Oil Prices: Spot and Futures Contracts(U.S. Dollars per barrel)
40

35

30

Spot Price1
25

20

Futures on April
29, 2003

15

10
1990

1991

1993

1995

1996

1998

2000

2001

2003

1Spot Price are monthly averages of West Texas through April 2003.

b. Commodity Prices(Index; 1990=100)
160

140

Non-Fuel
120

100

80

60

40
1990

Fuel

1991

1993

1995

1996

1998

2000

Metals2001

- 54A Chart 7a. GDP Growth and Output Gap in G-7(percent change from a year earlier)
Output Gap
GDP Growth6

6

United States

4

4

2

2

0

0

-2

-2
-4

-4
1990

Canada

1992

1994

1996

1998

2000

1990

2002

1992

1994

1996

1998

2000

2002

1996

1998

2000

2002

1996

1998

2000

2002

6

6

Japan

Germany

4

4

2

2

0

0

-2

-2

-4
1990

1992

1994

1996

1998

2000

2002

6
4

-4
1990

6

France

2

0

0

-2

-2

-4
1994

1996

1998

2000

2002

1994

1996

1998

2000

2002

Italy

2
0
-2
-4
1990

United Kingdom

-4
1992

6
4

1994

4

2

1990

1992

1992

1990

1992

1994

- 54B Chart 7b. GDP Growth and Output Gap in Asian Emerging Market Economies(percent change from a year earlier)

Output Gap
GDP Growth

12
8

12

China

4

4

0

0

-4

-4

-8

-8
-12

-12
1990

12

Korea

8

1992

1994

1996

1998

2000

1990

2002

12

Hong Kong SAR

8

8

4

4

0

0

-4

-4

-8

-8

-12

1992

1994

1996

1998

2000

2002

Taiwan Province of China

-12

1990

12

1992

1994

1996

1998

2000

2002

1990

8

4

4

0

0

-4

-4

-8

-8

-12
1992

1994

1996

1998

2000

2002

1996

1998

2000

2002

12

Thailand

8

1990

1992

1994

1996

1998

2000

2002

Singapore

-12
1990

1992

1994

- 54C Chart 7c. GDP Growth and Output Gap in other Emerging Market Economies(percent change from a year earlier)

Output Gap
GDP Growth

12
10
8
6
4
2
0
-2
-4
-6
-8
-10
1990

12
10
8
6
4
2
0
-2
-4
-6
-8
-10

12
10
8
6
4
2
0
-2
-4
-6
-8
-10

Brazil

1992

1994

1996

1998

2000

12
10
8
6
4
2
0
-2
-4
-6
-8
-10

Mexico

1990

12
10
8
6
4
2
0
-2
-4
-6
-8
-10
1990

1992

1994

1996

1998

2000

2002

(-18.6)

1994

1996

1998

2000

2002

1992

1994

1996

1998

2000

2002

1994

1996

1998

2000

2002

1996

1998

2000

2002

Poland

1990

12
10
8
6
4
2
0
-2
-4
-6
-8
-10

Russia

1992

1990

2002

Chile

1990

1992

South Africa

1992

1994

- 55 Chart 8a. Equity Prices in Industrial Countries(Log scale; index; Jan.7/00 = 100)
130

Japan
(TOPIX)

100

70

United Kingdom(FTSE 100)

Germany(DAX)

United States(S&P 500)

1995

1996

1997

1998

1999

2000

2001

2002

2003

Chart 8b. Equity Prices in Emerging Markets(Log scale; index; Jan.7/00 = 100)
130

Asia

100

Eastern Europe
70

Latin America

1995

1996

1997

1998

1999

2000

2001

2002

2003

- 56 Chart 9. Price Earning Ratios in Advanced Economies

40
35

United States

90
80

Japan

70

30

60

25

50

20

40

15

30

10

20

5

10

0

0

1987 1989 1991 1993 1995 1997 1999 2001 2003

1987 1989 1991 1993 1995 1997 1999 2001 2003

40
35

Germany

40
35

France

30

30

25

25

20

20

15

15

10

10

5

5

0

0
1987 1989 1991 1993 1995 1997 1999 2001 2003

1987 1989 1991 1993 1995 1997 1999 2001 2003

40
35

Italy

40
35

United Kingdom

30

30

25

25

20

20

15

15

10

10

5

5

0

0

1987 1989 1991 1993 1995 1997 1999 2001 2003

1987 1989 1991 1993 1995 1997 1999 2001 2003

40
35

Canada

30
25
20
15
10
5
0
1987 1989 1991 1993 1995 1997 1999 2001 2003

- 57 Chart 10. Real Effective Exchange Rates(index; 1990 = 100)

170

170

150

United States

130

130

110

90

United Kingdom

70

1992

1994

1996

1998

2000

2002

50
1990

1992

1994

1996

1998

2000

2002

170

Japan

150

Hong Kong SAR

150

130

130

110

110

90

90

70

70

50
1990

50

Taiwan Province of China

China
1992

1994

1996

1998

2000

2002

170

Thailand150
130

Singapore

110

Korea

70
50
1990

Canada

70

170

90

Euro Area1

110

90

50
1990

150

1992

1994

1996

1998

1. Synthetic euro prior to January 1999.

2000

2002

1990

1992

1994

1996

1998

2000

2002

- 58 Chart 11. Private Sector Credit(Nominal Credit Growth - Nominal GDP Growth: in percent)

10
8

10
8

United Kingdom

6
4
2

6
4
2

0
-2
-4
-6

United States
-8
-10
1990
1992
1994

10
8

Canada
1996

1998

2000

Japan

0
-2
-4
-6

2002

-8
-10
1990

1992

1994

1996

20

Italy1

2000

2002

1998

2000

2002

1998

2000

2002

Korea

15

6
4
2

1998

China

10
5
0

0
-2
-4
-6

-5

France-8 Germany
-10
1990
1992

1994

1996

1998

2000

-10

2002

-15

Hong Kong SAR

-20
1990

1992

1994

1996

1. break in series.

20
15

20
15

Thailand

10

10

5

5

0

0

-5
-10

India

-5

Singapore

-10

-15
-20
1990

Malaysia

-15

1992

1994

1996

1998

2000

2002

-20
1990

1992

1994

1996

- 59 Chart 12a. Stock Markets (Comparison of Japan, U.S. and Germany-Monthly Data)

Stock Market (-5 years)
500(Indices, 5 years ago = 100)

450

Germany (2000m3)

400
Japan (1989m12)
350
300
250
200
150
100

United States (2000m3)50
0-60 -55 -50 -45 -40 -35 -30 -25 -20 -15 -10 -5

05

10 15 20 25 30 35 40 45 50 55 60

Chart 12b. Real Residential Price Indices140(1992 = 100)
United Kingdom
120

United States
100

Japan
80

Germany

60
90

92

94

96

98

00

- 60A Chart 13a. China’s Trade Shares

US, Import Shares
25

20

15
Share of imports from China in total U.S. imports
Share of imports from Japan in total U.S. imports
Share of imports from the EU in total U.S. imports

10

5

20
01

19
99

19
97

19
95

19
93

19
91

19
89

19
87

19
85

19
83

19
81

19
79

19
77

19
75

0

China: Exports of Electronic Goods and Imports of Electronic Components
20000
18000
16000

Computer andtelecommunications

12000
10000
8000
6000
4000

Electronic integrated circuits
and microassemblies

2000
0

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

Japan, Import Shares
30
Share of imports from China in total Japan imports
Share of imports from US in total Japan imports

25

Share of imports from the EU in total Japan imports

20
15
10
5

01
20

99
19

97
19

95
19

93
19

91
19

89
19

87
19

85
19

83
19

81
19

79
19

77
19

75

0
19

Millions of US$

14000

- 60B Chart 13b. China-Regional and Global Trade

China's Exports as a percent of World Imports

5

4

3

2

1

0
1993

1994

1995

1996

1997

1998

1999

2000

2001

China's Exports as a percent of Region’s Exports
30

25

20

15

10

5

0
1993

1994

1995

1996

1997

1998

1999

2000

2001

Note: China's exports exclude those to the region.
Region comprises of Hong Kong SAR, Singapore, Thailand, Korea, Taiwan Province of China, Malaysia, Indonesia,
and Philippines.

- 61 Chart 14. China-Transmission of Deflation(Change in Inflation in Partner Countries in Response to a 0.7 Percentage Point (One Standard Deviation) Increase in Inflation in China)(year-on-year rates, monthly, in percent)
Hong
Kong
Hong
Kong
SAR

Taiwan of China
Taiwan Province.8.6Singapore

.7

.28

.6

.24
.20

.5
.4

.16

.4

.12
.3

.2

.08

.2
.0

-.2
2

4

6

8

10

12

14

16

18

20

22

.04

.1

.00

.0

-.04

24

2

4

6

8

10

Malay sia

12

14

16

18

20

22

24

2

4

6

8

10

Thailand

.25

.6

.20

.4

.15

.2

.10

.0

.05

-.2

.00

-.4

12

14

16

18

20

22

24

16

18

20

22

24

16

18

20

22

24

16

18

20

22

24

India
.6

.4

.2

.0

-.2

-.6

-.05
2

4

6

8

10

12

14

16

18

20

22

24

-.4
2

4

6

8

10

Indonesia

12

14

16

18

20

22

24

2

4

6

8

10

Korea

2

14

Japan

.4

.24
.20

.3

1

12

.16
.2

.12

0
.1

.08

-1

.04

.0

.00

-2

-.1

-.04

-.2

-3
2

4

6

8

10

12

14

16

18

20

22

24

-.08
2

4

6

8

10

UnitedU.K.
Kingdom

12

14

16

18

20

22

24

2

.12

.08

.10

.10

.05

.08

.00

.06

-.05

.04

-.10

.02

.04
.00
-.04
-.08
-.12

-.15

.00

-.20

-.02

-.25

-.16
6

8

10

12

14

16

8

18

20

22

24

10

12

14

U.S.
UnitedStates.15

4

6Germany

.12

2

4

-.04
2

4

6

8

10

12

14

16

18

20

22

24

2

4

6

8

10

12

14

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