by Calculated Risk on 8/02/2010 08:15:00 PM

A few excerpts from Professor Krugman: Why Is Deflation Bad?

There are actually three different reasons to worry about deflation, two on the demand side and one on the supply side.

So first of all: when people expect falling prices, they become less willing to spend, and in particular less willing to borrow. ....

A second effect: even aside from expectations of future deflation, falling prices worsen the position of debtors, by increasing the real burden of their debts. Now, you might think this is a zero-sum affair, since creditors experience a corresponding gain. But as Irving Fisher pointed out long ago (pdf), debtors are likely to be forced to cut their spending when their debt burden rises, while creditors aren’t likely to increase their spending by the same amount. ...

Finally, in a deflationary economy, wages as well as prices often have to fall – and it’s a fact of life that it’s very hard to cut nominal wages — there’s downward nominal wage rigidity. ...

Now, alert readers will have noticed that none of these arguments abruptly kicks in when the inflation rate goes from +0.1% to -0.1%. Even with low but positive inflation the zero lower bound may be binding; inflation that comes in lower than borrowers expected leaves them with a worse debt burden than they were counting on, even if the inflation is positive; and since relative wages are shifting around all the time, some nominal wages will have to fall even if the overall rate of inflation is a bit above zero.

There are more details at Krugman's post.

The third point on sticky wages (and prices) is very important. Relative wages are being adjusted all the time in the economy. With some inflation, real wages can be cut (if needed) by keeping wage increases below the inflation rate. However, if inflation is near zero - or there is deflation - many companies that need to cut wages a little will have difficulty competing since it is difficult to cut nominal wages. This is a key reason why a little inflation is better than no inflation. Of course too much inflation is really bad too, but that isn't the problem right now.