Classical Deflation Theory

D eflation, the opposite of inflation, is a situation of falling general prices. It should not be confused with disinflation, which refers to a declining inflation rate that nevertheless remains positive. It was the successful U.S. disinflation of the 1990s, a disinflation that lowered the inflation rate sufficiently to create concern that further downward pressure might push it into negative territory, that spurred recent fears of deflation. These fears have materialized in Japan, where deflation coincides with cyclical recession and stagnant growth. Most famously, deflationary fears became reality in the 1929–1933 Great Contraction in the United States when prices fell by a fourth while output was falling by two-fifths. Such episodes indicate that dread of deflation stems from its association with unemployment, business failures, and financial stress. Deflation tends to occur in cyclical slumps when collapses in aggregate spending force producers to cut prices continuously in a desperate effort to attract buyers. While these cuts eventually help to revive economic activity, they hardly work instantaneously. In the meantime, output and employment languish. The best alternative, therefore, may be to avoid deflation altogether by deploying monetary and fiscal policies sufficient to maintain economic activity at full capacity levels with low and stable inflation. Absent in much of the recent worry over falling prices is the recognition that deflation is hardly a new topic or a new event. Classical (circa 1750– 1870) monetary theorists, in particular, had much to say about it. Classicals, of course, abhorred deflation because, when unanticipated, it occasioned arbitrary and unjust redistributions of income and wealth from debtors to creditors. But classicals looked beyond these distributional outcomes involving equal but opposite transfers from losers to gainers to deflation’s adverse effects on output and employment. As we will see, classicals attributed such adverse effects to