Deflation, Depression, and the Zero Lower Bound

Sebastien Buttet and Udayan Roy

December 6, 2011

Abstract

We analyze the dynamic paths of output, interest rates, and inflation in a sim-
ple New Keynesian model of the business cycle that explicitly incorporates the zero
lower bound on nominal interest rates. We show that two long-run equilibria exist,
one stable and the other unstable, and we characterize the conditions under which
the economy plunges into a deflation-induced depression following a contractionary
demand shock. We study the policy-makers ability to (i) keep an economy out
of a deflationary spiral and (ii) end a deflationary spiral that has already begun.
Qualitatively, expansionary fiscal policy is an adequate response to both (i) and (ii),
while expansionary monetary policyspecifically, an increase in the target inflation
rateis a partial answer to (i) only. Quantitatively, our calibration exercise sug-
gests that a modest rise in the Feds inflation target from two to three percent is
enough to prevent the start of a deflationary spiral. On the other hand, only large
fiscal stimulus packages have a chance to pull the economy out a deflationary spiral,
when it is already in one.

JEL Classification: E12, E52, E62

Key Words: Deflation, Depression, Zero Lower Bound, Monetary Policy, Fiscal
Policy

Economics Department, C.W. Post Campus, Long Island University, Brookville, NY 11548. Email:
udayan.roy@liu.edu. Phone: 516 299 2321. Thanks to Veronika Dolar for helpful comments. All errors
are ours.

1
1 Introduction
Just a few years before the financial crisis hit, economists and central bankers generally
agreed that business cycles were a phenomenon of the past. Robert Lucas, in his pres-
idential address to the American Economic Association, declared that the problem of
depression preventionwhich gave birth to the field of macroeconomics during the Great
Depressionwas solved (Lucas, 2003). In another famous speech, the current chairman
of the Federal Reserve System attributed a large part of the decline in macroeconomic
volatility over the past thirty yearsthe so-called Great Moderation periodto improved
monetary policy and better use of the Taylor rule (Bernanke, 2004).
The Great Recession of 2008 challenged the neoclassical synthesis and forced policy-
makers to take the twin threats of deflation and depression seriously. There was a tight
link between deflation and depression during the Great Depression years and many be-
lieve that deflation contributed to the severe output losses in the U.S. and other countries
between 1929 and 1932 (Bernanke and Carey, 1996; Eichengreen and Sachs, 1985). In ad-
dition, memories of the Great Depression and to a lesser extent the Japanese Lost Decade
of the 1990s, continue to influence the decisions of policymakers who, to this day, remain
reluctant to adopt any policy that may cause deflation (Bernanke, 2002). For example,
the Friedman rule, which calls for a modicum of anticipated deflation (Friedman, 1969),
is rarely implemented by central banks, even though it is well-known that zero nominal
interest rates lead to an optimal allocation of resources under fairly broad conditions
(Chari et al., 1996; Cole and Kocherlakota, 1998; Lagos, 2010).
Outside of the Great Depression years, however, the empirical link between deflation
and depression is much weaker. Analyzing more than one hundred years of data on
inflation and output growth for 17 countries, Atkeson and Kehoe (2004) show that ninety
percent of episodes with deflation did not lead to depression, while thirty percent of
depression episodes had no deflation. According to Rolnick and Weber (1997), there
is only weak evidence supporting a long-run positive relationship between inflation and
output growth rates for countries using fiat money systems. Finally, higher inflation rates
are associated with lower output growth for the years after WWII (Atkeson and Kehoe,
2004; Benhabib and Spiegel, 2009).

2
 Why is the correlation between inflation and output growth tight during the Great
Depression but weak in other time periods? Why do central banks rarely implement the
Friedman rule? Are policymakers over-concerned about episodes of mild deflation? To
answer these questions and contribute to the deflation-depression debate more generally,
we extend a simple 3-equation New Keynesian model of the business cycle, by adding
of a non-negativity constraint on nominal interest rates. To be sure, a large and rapidly
growing body of empirical and theoretical research has already studied the impact that the
zero lower bound has on the economy, including the restrictions it places on the use of the
conventional tools of monetary and fiscal policy (e.g., Eggertsson and Woodford (2003);
Bernanke et al. (2004); Woodford (2010); Correia et al. (2011)). What sets our research
apart, however, is that we concentrate our analysis on the deflation-depression link and
fully characterize the conditions under which a deflation-induced depression occurs.
The properties of our model without the zero lower bound are well known (Mankiw,
2010; Carlin and Soskice, 2006). Output and real interest rates are pro-cyclical and, in the
absence of shocks, all variables converge toward a unique stable equilibrium, where the
economy is operating at full capacity and inflation is equal to the central banks inflation
target.
The introduction of the zero lower bound changes the model dynamics along several
dimensions. First, the correlation between output and real interest rates becomes neg-
ative, which implies that changes in real interest rates reinforce (rather than dampen)
changes in output when the zero lower bound is binding. Second, we find that an addi-
tional unstable equilibrium exists when the zero lower bound is binding. Third, there is
a one-to-one relationship between the inflation level and whether the zero lower bound is
binding. We show that a critical threshold for inflation exists such that the zero lower
bound becomes binding when inflation falls below the threshold. Finally, the inflation
reaction function, which links inflation across two consecutive time periods, is no longer
linear but is kinked at the inflation threshold.
The negative feedback loop between output and inflation is the mechanism that leads
to a deflation-induced depression, as previously explained by Fisher (1933) or Krugman
(1998). In normal times, when nominal interest rates are positive, the central bank

3
can afford to cut interest rates following a negative demand shock to provide short-term
stimulus to the economy. When the zero-lower bound is binding, however, cutting rates
is not feasible and real interest rates spike up as a result of lower inflation. Higher real
rates in turn depress the economy further, which put further pressure on real rates, which
depress the economy further, and so on and so forth.
For a given set of parameter values and initial conditions, some interesting questions
arise. First, to which of the two equilibria does inflation and output converge? Second,
can the model generate a deflation-induced depression and if yes, are there equilibrium
paths where deflation does not lead to depression? Third, how large should a negative
demand shock be to trigger a depression? Finally, how effective are monetary and fiscal
policy are at preventing or stopping the deflationary spiral?
We find that answers to the first two questions depend on the sign of a simple ex-
pression, the sum of the inflation rate and the natural rate of interest. We show that,
as long as the sum of the inflation rate and the natural real interest rate stays positive,
the economy converges back to the long-run stable equilibrium, even when the zero lower
bound is initially binding. On the other hand, a deflationary spiral starts when the sum
of the inflation rate and the natural rate of interest becomes negative. One scenario that
makes the sum of the inflation rate and the natural rate negative is a large contractionary
demand shock that induces a sudden fall in the inflation rate. However, since this scenario
has a small probability of occurrence, few equilibrium paths lead to a depression.
Our theoretical results that (i) mild deflation does not lead to a depression and (ii)
deflation and depression are closely linked when the economy is hit by a large demand
shock, shed light on the aforementioned empirical findings of Atkeson and Kehoe (2004)
and Benhabib and Spiegel (2009). Since the likelihood of a large negative demand shock
is small, the model dynamics for output and inflation are consistent with the fact that
the deflation-depression link is strong for the Great Depression years and weak for other
years.
The results (i) and (ii) also help explain why central banks rarely implement the
Friedman rule as the optimal monetary policy. The Friedman rule, which calls for a
small dose of anticipated deflation, takes the sum of the inflation rate and the natural

4
real interest rate uncomfortably close to zero, and thereby raises the probability of the
economy plunging into a depression.
We also study the effectiveness of monetary and fiscal policy in dealing with the de-
flationary spiral. We distinguish between prevention and remedy, as proposed by Ben
Bernanke in his 2002 speech about deflation (Bernanke, 2002), and ask two simple ques-
tions: (i) What can be done to keep an economy away from the deflationary spiral? (ii)
Can policy get an economy out of a deflationary spiral, if it is already in one? None of
the channels of unconventional monetary policy at the zero lower bound are at work in
our model. By monetary policy, we mean a change in the parameters of the Taylor rule,
including the central banks inflation target, and by fiscal policy, we mean changes in
government spending and taxes. We show that expansionary fiscal policy is an adequate
answer to both questions, while expansionary monetary policyspecifically, an increase
in the target inflation rateis a partial answer to (i) only.
Finally, we simulate our model to illustrate how output and inflation respond to a four-
period contractionary demand shock when the zero lower bound is binding. We do not see
the simulation as a calibration exercise (we are not aiming to match any moment of the
data), but our quantitative endeavor allows us to answer two important questions. First,
how large should a demand shock be to trigger a depression? Second, how aggressive
should the policy response be to prevent or cure a depression? We find that it takes
an output loss of at least 24 percent over four consecutive periods to trigger a deflation-
induced depression and that the likelihood that such large shocks occur is infinitesimal. To
put things into perspective, output in the U.S. during the Great Depression contracted by
46 percent between 1929 and 1932. The answer to the second question is also encouraging.
Everything else equal, a modest rise in the central banks inflation target from 2 to 3
percent is enough to prevent the start of a deflationary spiral. On the other hand, only
large fiscal stimulus packages (expressed as a fraction of the natural level of output) have
a chance to get the economy out the deflationary spiral, when it is already in one.
The remainder of the paper is organized as follows. In Sections 2 and 3, we introduce
our model and characterize its long-run equilibria. We discuss the stability of these
equilibria in Section 4. We reinterpret empirical findings in light of our theoretical results

5
in Section 5. We study the policy responses to a deflationary environment in Section 6
and present some numerical simulation results in Section 7. Finally, we offer concluding
remarks in Section 8.

2 The Model
We extend a simple New Keynesian model of the business cycle by explicitly incorporating
a non-negativity constraint on nominal interest rates. The version of our model without
the zero lower bound has replaced the IS-LM model as the mainstay of short-run analysis
in macroeconomics textbooks and is variously referred to as the dynamic AD-AS (or DAD-
DAS) model in Mankiw (2010), the AS/AD model in Jones (2011), and the 3-equation
(IS-PC-MR) model in Carlin and Soskice (2006), where PC refers to the Phillips Curve
and MR refers to the central banks Monetary Policy Rule.
Equilibrium in the market for goods and services is given by

Yt = Yt (rt ) + t (1)

where Yt denotes the natural or full-employment level of output, rt is the real interest rate,
is the natural real interest rate of interest, is a positive parameter representing the
responsiveness of aggregate expenditure to the real interest rate, and t represents both
demand shocks (say, from changes in private-sector optimism or animal spirits) and the
governments fiscal policy stance.
This equation is essentially the well-known IS Curve. The key feature of (1) is the
negative relationship between the real interest rate rt and output Yt . When the real
interest rate increases, borrowing becomes more expensive and savings yields a higher
reward. As a result, firms engage in fewer investment projects and consumers save more
and spend less. These effects reduce the demand for goods and services.
The shock t represents exogenous shifts in demand that arise from changes in con-
sumer and/or business sentimentthe so-called animal spiritsand changes in fiscal
policy. When the government implements an economic stimulus (an increase in govern-
ment expenditure or a tax cut), t is positive, while fiscal austerity means a negative t .
Note that the economy operates at full capacity (Yt = Yt ) when there are no demand

6
shocks (t = 0) and when the real interest rate is equal to the natural real interest rate
(rt = ).
The ex-ante real interest rate in period t is determined by the Fisher equation and is
equal to the nominal interest rate it minus the inflation expected in the next period:

rt = it Et t+1 (2)

Inflation in the current period, t , is determined by a conventional Phillips curve

augmented to include the role of expected inflation, Et1 t , and exogenous supply shocks,
t :
t = Et1 t + (Yt Yt ) + t (3)

with is a positive parameter.

Inflation depends on expected inflation because some firms set prices in advance. When
these firms anticipate high inflation, they expect their own costs to be rising quickly and
that their competitors will be implementing price hikes. The expectation of high inflation
induces these firms to announce price increases for their products, which in turn cause
high actual inflation in the economy. Conversely, when firms expect low inflation, they
forecast that their costs and competitors prices will rise only modestly. In this case, they
keep price increases in check, which leads to low inflation.
The business cycle also affects inflation that goes up when output rises above its natural
level, since the parameter is positive. When the economy is booming and output rises
above its natural level, firms experience increasing marginal costs and so they raise their
prices. Conversely, when the economy is in recession and output is below its natural level,
marginal costs fall and firms cut prices, which results in low inflation.
The random variable t captures all other influences on inflation other than inflation
expectations (which are captured in the term Et1 t ) and short-run economic conditions
(which are captured in the term (Yt Yt )). For example, an increase in oil prices would
mean a positive value for t since higher input prices might force firms to raise the price
of their products.
Inflation expectations play a key role in both the Fisher equation (2) and the Phillips
curve (3). To keep the model tractable analytically and because the role of expectations
was analyzed in great detail in Eggertsson and Woodford (2003, 2004), we assume that

7
inflation in the current period is the best forecast for inflation in the next period1 . That
is, agents have adaptive expectations with:

Et t+1 = t (4)

Finally, we complete the description of the model with a rule for monetary policy.
Dynamic New Keynesian models assume that the central bank sets a target for the nominal
interest rate, it , based on the inflation gap and the output gap according to the Taylor
rule (Taylor, 1993). Specifically, it is assumed that it = t + + t (t t ) + Y t (Yt Yt ),
where the central banks policy parameters t and Y t are non-negative. We, however,
wish to explicitly incorporate the fact that nominal interest rates need to be non-negative.
Therefore, our monetary policy rule is:

it = max{0, t + + t (t t ) + Y t (Yt Yt )}. (5)

Although the central bank sets a target for it , its true influence on the economy works
through the real interest rate, rt . When inflation in period t is equal to the central
banks target (t = t ) and output is at its natural level (Yt = Yt ), the last two terms in
equation (5) are equal to zero, implying that the real rate is equal to the natural rate of
interest (rt = ). As inflation rises above the central banks target (t > t ) or output
rises above its natural level (Yt > Yt ), the Taylor rule ensures that the real rate rises to
bring down inflation and/or output. Conversely, if inflation falls below the central banks
target (t < t ) or output falls below its natural level (Yt < Yt ), the real interest falls to
provide a stimulus to the economy.
For given values of the models period-t parameters (, , , t , Y t , t , and Yt ),
its period-t shocks (t and t ), and the pre-determined inflation rate (t1 ) for period
1
Following seminal papers by Lucas (1972, 1976), there is a long tradition in the field of macroeco-
nomics to build models where agents have rational expectations. More recently, a line of research by
Hansen and Sargent (2008) explores a class of mechanisms for expectations formation based on robust
control, which captures the idea that the decision-maker has an imperfect understanding of how the
economy works. Sims (2003, 2006) most recent work explores a new theory for expectations formation
based on rational inattention, which captures agents limited capacity to process information. Finally,
Chow (2011) provides strong empirical evidence for supporting the adaptive expectations hypothesis
in economics and points out that the rational expectations hypothesis was embraced by the economics
profession too quickly.

8
t 1, one can use the the models five equations to solve for its five period-t endogenous
variables (Yt , rt , it , Et1 t , and t ). Once t is determined, the process can be repeated
for period t + 1, and so on and on.
To study the models dynamic properties algebraicallyas opposed to numerically
we will simplify the model by assuming a constant target inflation rate: that is, t =
for all t.

3 Long-Run Equilibria
An equilibrium sequence is any intertemporal sequence of values for the models endoge-
nous variables such that the models equations (1)(5) are satisfied. A long-run equilibrium
is any equilibrium sequence such that, in the absence of shocks (t = t = 0 for all t), the
inflation rate is constant (t1 = t = t+1 = . . .).
It is then straightforward to identify the two long-run equilibria of the model. First,
one can check that if t1 = and there are no shocks, then t+s = , Yt+s = Yt+s ,
rt+s = , and it+s = + for s = 0, 1, 2, . . .. We will refer to this long-run equilibrium
as the orthodox equilibrium.
To ensure that the orthodox long-run equilibrium does not run afoul of the zero lower
bound on the nominal interest rate we assume + > 0 or, equivalently > .
Second, one can check that, if t1 = and there are no shocks, then t+s = ,
Yt+s = Yt+s , rt+s = , and it+s = max{0, + + ,t+s ( ) + Y,t+s (Yt+s
Yt+s )} = 0 for s = 0, 1, 2, . . .. We will refer to this long-run equilibrium as the deflationary
equilibrium.
To summarize, we have the following:

Proposition 1. Once the DAD-DAS model is generalized to allow the zero lower bound
on the nominal interest rate to be binding, it has two long-run equilibria: an orthodox
equilibrium that is obtained when t1 = > and a deflationary equilibrium that is
obtained when t1 = .

9
4 Stability of Equilibrium
The issue of stability inevitably arises: How does the economy behave for arbitrary values
of t1 ? Will it converge to one of the two long-run equilibria? If so, which one?
To analyze the stability properties of the DAD-DAS model, we need to solve for the
models endogenous variables for the case in which the zero lower bound on the nominal
interest is not binding and again for the case in which the zero lower bound is binding.

4.1 Zero Lower Bound is Non-Binding

When the zero lower bound is not binding, the monetary policy rule (5) becomes

it = t + + t (t t ) + Y t (Yt Yt ). (6)

Therefore, the economy is described by equations (1)(4) and (6). Using these equations,
it is straightforward, if tedious, to derive expressions for the models endogenous variables
in terms of the parameters of the model and the pre-determined inflation rate of the
previous period. Specifically, it can be shown that equilibrium output is

t (t t1 t ) + t
Yt = Yt + , (7)
1 + (t + Y t )

equilibrium inflation is

(1 + Y t ) (t1 + t ) + t t + t
t = , (8)
1 + (t + Y t )

and the equilibrium nominal interest rate is

1
it = + {(1 + t + Y t )(t1 + t ) (1 )t t + (Y t + (1 + t ))t } .
1 + (t + Y t )
(9)
As the Fisher equation (2) and adaptive expectations (4) imply rt = it t , the
equilibrium real interest rate can be derived from equations (8) and (9) above.
It follows from (7) that, in the usual case where the zero lower bound on the nominal
interest rate is not binding, output (Yt ) is directly related to full-employment output
(Yt ), the demand shock (t ), and the central banks target inflation (t ), and inversely
related to the previous periods inflation (t1 ), the inflation shock (t ), the responsiveness

10
of inflation to output in the Phillips Curve (), and the responsiveness of the nominal
interest rate to output in the monetary policy rule (Y t ).
It follows from (8) that inflation (t ) is directly related to t1 , t , t , and t . We
will see in section 6 that these comparative static results for inflation play an important
policy role in the dynamic stabilization of the economy.
Figure 1 graphs the dynamic mapping from t1 to t for given values of all the
parameters in equation (8) and the shocks set at zero (t = t = 0). It can be checked
that this graphwhich we will call the inflation mapping curvemust intersect the 45-
degree line at t1 = t , because t1 = t implies t = t1 = t . This represents the
orthodox long-run equilibrium of Proposition 1.
Note also that the inflation mapping curve must be flatter than the 45-degree line as
its slope is a positive fraction: that is, t /t1 = (1 + Y t )/(1 + Y t + t ) (0, 1).
As is shown in Figure 1, this feature of the inflation mapping curve when the zero lower
bound on the nominal interest rate is not binding and there are no shocks implies that the
orthodox long-run equilibrium of Proposition 1 is stable. (The stability of the deflationary
long-run equilibrium will be discussed below.)
To guarantee the intuitive result that a positive demand shock increases output in
equation (14), we assume that 1 > 0 in this paper. It then follows from (9) that the
nominal interest rate, assuming it is not at the zero lower bound, is directly related to
and to all exogenous variables and shocks that are directly related to inflation.
Note that these results prevail only when it , as given by (9), is non-negative. It can
be checked that (9) implies

> >
it 0 if and only if t1 c , (10)
= t1

where

c (1 )t t (1 + t + Y t ) (t + Y t + )t
t1 t (11)
1 + t + Y t

is the critical value for the previous periods inflation rate such that the equilibrium
c
nominal interest rate is given by equation (9) when t1 t1 , and is zero when t1
c
t1 .

11
Figure 1: Dynamics without the zero lower bound on the nominal interest rate
The dynamic mapping from t1 to t when there are no shocks (t = t = 0) and the
zero lower bound on the nominal interest rate is non-binding is shown here. For any given
value of t1 , the inflation mapping curve and the 45-degree line can be used to trace
inflation in subsequent periods. The orthodox long-run equilibrium (t1 = ) can be
seen to be stable.

12
 The line segment BC in Figure 2 graphs the dynamic mapping from t1 to t in
c
equation (8) for t1 t1 when there are no shocks and the central bank has a constant
target inflation (t = ). A quick comparison of Figures 1 and 2 emphasizes the fact that
the introduction of the zero lower bound on the nominal interest rate sharply restricts
the domain over which equation (8) is applicable. Note, as before, that the coefficient of
t1 on the right hand side of equation (8) is a positive fraction, which explains why BC
is drawn flatter than the 45-degree line. At t1 = , BC intersects the 45-degree line,
indicating the orthodox long-run equilibrium of section 3. It can be checked from (11)
c
that, in the absence of shocks, t1 is a convex combination of and . Our assumption
that + > 0 then implies > t1
c
> , as shown in Figure 2.
In the absence of shocks (t = t = 0), equation (8) reduces to

t
t t1 = (t t1 ). (12)
1 + t + Y t

Note that whenever the central banks target inflation rate, t , exceeds (respectively, is
less than) the previous periods inflation, t1 , the current periods inflation rises (respec-
tively, falls), while still remaining less (respectively, greater) than the target inflation. In
c
other words, if there are no shocks and the target inflation is constant and t1 t1 ,
the inflation rate converges over time to the central banks target inflation rate.
Under adaptive expectations and in the absence of shocks, the Phillips Curve yields

t
(Yt Yt ) = t t1 = ( t1 ).
1 + t + Y t t

The convergence of inflation to target inflation therefore implies the convergence of equi-
librium output to the full-employment output. Therefore, according to the Taylor Rule
(5 or 6), the nominal interest rate set by the central bank will converge to i = + > 0.
And, by the Fisher equation (2) the real interest rate converges to .
We have, therefore, established the following:

c
Proposition 2. When there are no shocks and t1 t1 , the economy converges to the
orthodox long-run equilibrium.

13
4.2 Zero Lower Bound is Binding
c
It follows from (10) that, when t1 < t1 , the zero lower bound on the nominal interest
rate becomes binding: that is,
it = 0. (13)

In this case, recall that the economy is described by equations (1)(4) and (13). Using
these equations, it is straightforward, as before, to derive expressions for the endogenous
variables at time t in terms of the parameters of the model and the pre-determined inflation
rate of the previous period. Specifically, equilibrium output is

(t1 + t + ) + t
Yt = Yt + (14)
1

and equilibrium inflation is

1
t = (t1 + t ) + ( + t ). (15)
1 1

Note that the coefficient of t1 in (15) exceeds unity. This is why the segment AB in
c
Figure 2, which shows the dynamic link between t1 and t for t1 t1 when there
are no shocks, is steeper than the 45-degree line. Also, it can be checked that equating
c
the right hand sides of equations (8) and (15) yields t1 = t1 , thereby confirming the
c
continuity of the mapping of t1 to t at t1 = t1 in Figure 2.
The contrast between equation (7), when the zero lower bound is not binding, and
equation (14), when the zero lower bound is binding, is striking. It follows from (14)
that now t1 , t , and are directly related to output. Moreover, output is now directly
related to the responsiveness of aggregate demand to the real interest rate () and to
the long-run real interest rate (), and unrelated to all monetary policy tools (t , Y t ,
and t ). The ineffectiveness of monetary policy follows from the fact that the nominal
interest rate is now at the zero lower bound and monetary policy is, therefore, unable to
influence the nominal interest rate.
It follows from equation (15) that inflation is directly related to t1 , t , , and t , as
it is in equation (8), which describes inflation when the zero lower is not binding. Now,
however, and have a direct effect on inflation, and the monetary policy tools have no
effect at all (for the reason discussed in the previous paragraph).

14
 Subtracting t1 from both sides of equation (15) yields

t t1 = (t1 + ). (16)
1

This confirms our earlier result that when there are no shocks and t1 = , the economy
is in the deflationary long-run equilibrium of section 3.
However, equation (16) also reveals the unstable nature of the deflationary long-run
equilibrium. If there are no shocks and if t1 < , equation (16) implies that inflation
keeps falling and, by equation (14) drags output down with it, indefinitely. This is the
c
dreaded deflationary spiral. On the other hand, if there are no shocks and if t1 > t1 >
, inflation and output both keep rising. In short, we have established the following:

Proposition 3. Assume there are no shocks. The deflationary long-run equilibrium is

unstable.

c
As inflation keeps rising when there are no shocks and t1 > t1 > , equation (11)
c
implies that inflation will, in finite time, exceed t1 and that, therefore, the zero lower
bound on the nominal interest rate will switch from binding to non-binding.
Therefore, propositions 2 and 3 can be combined to yield the following:

Proposition 4. Assume there are no shocks. If t1 > , the economy converges to

the orthodox long-run equilibrium. If t1 = , the economy stays in the deflationary
long-run equilibrium. If t1 < , the economy stays in a deflationary spiral.

Proposition 4, which is graphically illustrated in Figure 1, helps explain why central

banks rarely implement the Friedman rule as the optimal monetary policy. The Friedman
rule, which calls for a small dose of anticipated deflation, makes the sum of inflation and
natural rate of interest very close to zero, which makes the economy vulnerable to further
shocks and raises the probability that the economy plunges into a depression.

5 Reinterpretation of Empirical Findings

In the introduction, we cited the empirical findings of Atkeson and Kehoe (2004), who
show that, while the deflation-depression link is strong for the Great Depression years,

15
Figure 2: Stability ABC represents the dynamic mapping from t1 to t when there
are no shocks (t = t = 0). AB represents an economy in which the zero lower bound
on the nominal interest rate is binding, and BC represents the same economy when the
zero lower bound on the nominal interest rate is non-binding. For any given value of
t1 , ABC and the 45-degree line can be used to trace inflation in subsequent periods.
The orthodox long-run equilibrium (t1 = ) can be seen to be stable, whereas the
deflationary long-run equilibrium (t1 = ) can be seen to be unstable.

16
there is little evidence supporting a statistical relationship between deflation and depres-
sion outside of the Great Depression years. Here we briefly summarize their empirical
strategy and revisit their findings in light of our results.
The authors use the following simple specification to estimate the relationship between
inflation and growth:
yit = + it + it (17)

where yit represents average annual growth for country i during five-year period t,
it represents average annual inflation for country i during five-year period t, and it
represents an i.i.d. normal disturbance term.
The data set consists of historical data on inflation and output growth rates for a
panel of 17 different countries. Every data series runs for more than a hundred years and
ends in the year 2000. The countries, with the year the data starts given in parenthe-
sis, are: Argentina (1885), Australia (1862), Brazil (1861), Canada (1870), Chile (1908),
Denmark (1871), France (1820), Germany (1830), Italy (1867), Japan (1885), the Nether-
lands (1900), Norway (1865), Portugal (1833), Spain (1849), Sweden (1861), the United
Kingdom (1870), and the United States (1820). For all countries except Australia and
Denmark, the data up to 1980 are taken from Rolnick and Weber (1997). The data for
Australia and Denmark up to 1980 are taken from Backus and Kehoe (1992). The data
from 1980 onwards are from the International Financial Statistics of the International
Monetary Fund.
Table 1 shows the estimation results for different time periods. For the Great Depres-
sion years, the point estimate for the slope is equal to 0.4, implying that, on average,
a one percentage point lower inflation rate is associated with a drop in growth of .4 of
a percentage point, say, from 3.40 to 3.00 percent. When the entire time period is con-
sidered, however, the value for drops to 0.08, implying a much weaker link between
inflation and growth between 1820 and 2000. Finally, the point estimate of is slightly
negative for the years after WWII.
Our theoretical results in Proposition 4 help explain the weak relationship between
inflation and output growth outside of the Great Depression years and the tight deflation-
depression link during the Great Depression years. When inflation falls below and a

17
depression starts, our model clearly predicts a tight link between deflation and depression
(see Figure 2). However, the probability of a large demand shock starting a depression
is very small. Thus, many equilibrium paths involve a mild case of deflation but no
depression, implying a small correlation between inflation and output growth even when
the zero lower bound is binding.

Table 1: Regression of Average Growth and Average Inflation (Std Dev in

parenthesis)

Episode Constant Slope

Great Depression Episode (1929-1934) 1.15 (1.24) .40 (.28)

Other Episodes (Excluding Great Depression)

Including World Wars 3.02 (.19) .04 (.03)
Excluding World Wars 2.96 (.15) .10 (.03)
Before Great Depression (Pre-1939) 2.35 (.18) .11 (.04)
After WWII (Post-1949) 4.00 (.28) -.03 (.04)

All Episodes (1820-2000) 2.74 (.17) .08 (.03)

Source: Atkeson and Kehoe (2004)

Using our model, we calculate the slope of the linear relationship between output
growth and inflation, when the zero lower bound is binding and when it is not. That is,
we seek to find the parameter such that

yt = + t + ut (18)
Yt+1 Yt
where yt = Yt
and ut is a disturbance term. Assuming that the natural output level
is constant over time and normalizing it to one, we use equations (7) and (8) to calculate
the slope when the zero lower bound is not binding and equations (14) and (15) when
it is binding. When the zero lower bound is not binding, we find that the value of is
approximately equal to:
2 2
P OS = (19)
(1 + Y )(1 + ( + Y ))

18
On the other hand, when the zero lower bound is binding, the slope is approximately
equal to:
2
ZLB = (20)
1
Some interesting remarks are in order. First, if one uses the values of = 1 and
= 0.25 as we will in our simulations, we find that ZLB = 0.33 when the zero lower
bound is binding, which is very close to the 0.4 estimate in Atkeson and Kehoe (2004)
for the Great Depression years, certainly a period of time when the zero lower bound was
binding. Second, we find that P OS = 0.025 if one sets Y = = 0.5 for the Taylor rule
as suggested by Taylor (1993). As a result, we have ZLB > P OS , which is also in line
with the results in Table 1. For example, the estimated slope for the Great Depression
years, when the zero lower bound is binding, is 0.4, while for the years excluding the
Great Depression but including the wars, the slope is = 0.04.

6 Policy Responses to Deflationary Spirals

Given that a deflationary spiral is an undesirable outcome, (i) what can be done to keep an
economy away from it, and (ii) what can be done to get an economy out of a deflationary
spiral if it is already in one? None of the channels of unconventional monetary policy at
the zero lower bound are at work in our model.2 By monetary policy, we mean a change
in the parameters of the Taylors rule, including the Feds inflation target, and by fiscal
policy, we mean increased government spending.
We will show that expansionary fiscal policy is an adequate answer to both questions,
and expansionary monetary policyspecifically, an increase in the target inflation rateis
an answer to (i).
2
Bernanke et al. (2004) discuss the policy tools that central banks can use when the zero lower bound
is binding, including balance sheet expansion through quantitative easing; changing the composition
of the Feds balance sheet through, for example, the targeted purchases of long-term bonds as a means
of reducing the long-term interest rate; or using communication to shape public expectations about the
future course of interest rates.

19
6.1 Avoiding a Deflationary Spiral

From Proposition 4, we see that, if t1 and there are no shocks from period t
onwards, the economy will not enter a deflationary spiral. However, the possibility of
adverse shocks in period t cannot be wished away. We need to ask what can be done in
period t to neutralize adverse period-t shocks that can cause a deflationary spiral from
c
period t + 1 onwards. We will consider two cases: Case 1A: t1 t1 > , and Case
c
1B: t1 t1 .

c
6.1.1 Case 1A: t1 t1 >

Equation (10) implies that in this case the zero lower bound on the nominal interest rate
is not binding. Therefore, equation (8) gives us the period-t inflation rate, t . By Propo-
sition 4, if there are no further shocks from period t+1 onwards, we need t > to avoid
a deflationary spiral (from period t + 1 onwards). It is clear from equation (8) that a large
enough and negative inflation shock and/or demand shock (from falling private-sector
confidence, for example) could lead to t < (and, therefore, a deflationary spiral).
However, equation (8) also makes clear that this danger can be neutralized by expansion-
ary fiscal policy (t ) and/or an increase in the central banks target inflation ( ). (As
is clear from equation (8), the effects of t and Y t , which represents the responsiveness
of the central banks interest-setting rule to inflation and output, respectively, on inflation
are ambiguous.)
These issues can be explored graphically. Let us refer to ABC in Figure 2 as the
inflation mapping curve. Figure 3 shows the effect on the inflation mapping curve of
contractionary monetary policy in the form of a reduction in the central banks inflation
target, and Figure 4 shows the effect of fiscal austerity. In Figures 5 and 6, a reduction in
private-sector demand lowers the inflation mapping curve from ABC to A1 B 1 C 1 , thereby
threatening to reduce inflation below and initiation a deflationary spiral. However,
Figures 5 and 6 show that with a timely increase in the inflation target (as in Figure 3)
or in the fiscal stimulus (as in Figure 4) we can avoid a deflationary spiral.

20
Figure 3: Monetary Policy When there is a decrease in t , the mapping from t1 to
t changes from ABC to AB 1 C 1 .

c
6.1.2 Case 1B: t1 t1

Equation (10) implies that in this case the zero lower bound on the nominal interest rate
is binding. Therefore, t is now obtained from equation (15). As in Case 1A above, a
large enough and negative inflation shock and/or demand shock can initiate a deflationary
spiral from period t + 1 onwards. However, as equation (15) makes clear, expansionary
fiscal policy (t ) can neutralize the threat of a deflationary spiral, as was the case in Case
1A. Note that, in contrast to Case 1A, changes in are now of no help as a preventive
strategy. This is because monetary policy cannot affect an economy that is at the zero
lower bound.
To summarize, raising the inflation target can keep help us avoid a deflationary spiral,
c
but only when such a spiral is already unlikely (Case 1A: t1 t1 > ). Expansion-
ary fiscal policy, on the other hand, works as a preventive in all cases.

21
Figure 4: Fiscal Policy When there is a decrease in t either because of a decrease
in private-sector confidence or because of fiscal austeritythe mapping from t1 to t
changes from ABC to A1 B 1 C 1 .

22
Figure 5: Monetary Policy to Avoid a Deflationary Spiral Suppose, as in Figure 4,
a decrease in private-sector confidence lowers the inflation mapping curve from ABC to
A1 B 1 C 1 , and suppose t1 = as in the orthodox long-run equilibrium and is denoted
by point D. In this case, t would fall below and a deflationary spiral would begin,
unless preventive measures are taken. An increase in the central banks inflation target,
, that raises the inflation mapping curve to A1 B 2 C 2 (or higher) averts the spiral. (See
Figure 3 for the effect of on the inflation mapping curve.)

23
Figure 6: Fiscal Policy to Avoid a Deflationary Spiral Suppose, as in Figure 4,
a decrease in private-sector confidence lowers the inflation mapping curve from ABC to
A1 B 1 C 1 , and suppose t1 = as in the orthodox long-run equilibrium and is denoted
by point D. In this case, t would fall below and a deflationary spiral would begin,
unless preventive measures are taken. The implementation of fiscal stimulus (t ) that
raises the inflation mapping curve to A2 B 2 C 2 (or higher) averts the spiral. (See Figure 4
for the effect of t on the inflation mapping curve.)

24
6.2 Getting Out of a Deflationary Spiral

Assume t1 < . Then, by Proposition 4 and assuming no further shocks from period t
onwards, a deflationary spiral will begin in period t. We can, however, rescue this economy
by doing something in period t to ensure t > . As the discussion immediately following
c
equation (11) makes clear, we have t1 < < t1 , which implies that the zero lower
bound on the nominal interest rate is binding (it = 0). Therefore, we can seek guidance
from equation (15). It is clear from equation (15) that the only way out is expansionary
fiscal policy (t ). As we saw before, monetary policy is useless when the nominal interest
rate is stuck at zero.
Figure 7 demonstrates the role of fiscal stimulus in rescuing and economy from a
deflationary spiral.
To summarize our discussion of policy responses to a deflationary spiral, we state the
following:

Proposition 5. A deflationary spiral can be prevented by raising the target inflation

rate, but only when the previous periods inflation is high enough. Other monetary policy
tools have an ambiguous preventive role. Expansionary fiscal policy can be used for both
prevention and cure.

7 Simulations
We present some numerical simulations of the model given the parameter values in Table 2.

Table 2: Parameter Values

Yt Y
100 1.0 2.0 0.25 0.5 0.5 2.0

The first three parameters (Yt , , ) appear in the aggregate demand equation (1). A
value of 100 for the natural level of output is convenient as fluctuations in Yt Yt can
be interpreted as percentage deviation of output from its natural level. The parameter

25
Figure 7: Fiscal Policy to Recover from a Deflationary Spiral Suppose the mapping
from t1 to t is represented by ABC and t1 is given by point D and, therefore, is less
than . Therefore, a deflationary spiral has already begun. However, a fiscal stimulus
(t ) that raises the inflation mapping curve to A1 B 1 C 1 (or higher) pushes t above ,
thereby stopping the spiral. (See Figure 4 for the effect of t on the inflation mapping
curve.)

26
 = 1 implies that a one percentage point increase in the real interest rate reduces the
output gap by one percentage point. The natural rate of interest is equal to 2 percent,
in line with historical data. The parameter appears in the Philips curve in equation (3).
The value of 0.25 implies that inflation rises by 0.25 percentage point when output is one
percent above its natural level. Finally, the last three parameters affect the Taylor rule
in equation (5). The value of one half for the coefficients and Y stems directly from
Taylor (1993). For each percentage point that inflation rises above the Feds inflation
target, the federal funds rate rises by 0.5 percent. For each percentage point that real
GDP rises above the natural level of output, the federal funds rate rises by 0.5 percent.
Since is greater than zero, our equation for monetary policy follow the Taylor principle:
whenever inflation increases, the central bank raises the nominal interest rate by an even
larger amount3 . Finally, the inflation target is equal to 2 percent, reflecting the Feds
concerns of keeping inflation under control, a policy that started thirty years ago under
chairman Paul Volcker.
We present below the paths for output, inflation, nominal and real interest rates when
the economy is hit by a four-period contractionary demand shock. In the first experiment,
where the demand shock t is equal to -3 in periods 3 to 6 and zero elsewhere, the zero
lower bound is not binding in any period. The dynamics of the economy are well known,
with output and real interest rates being pro-cyclical (Figure 8(a) to 8(e)). In response to
the demand shock in period 3, output falls below the natural level and inflation is lower
than the Feds target. Monetary policy becomes accommodative and with nominal interest
rates falling faster than inflation, declining real interest rates boost output between period
4 and 6. Finally, when the demand shock subsides in period 7, output overshoots and
then converges to the natural level and real interest rates remain below the natural rate
3
Clarida et al. (2000) examine data on inflation, interest rates, and output and estimate the coefficients
of the Taylor rule at different points in time. During the Volcker-Greenspan area, they find that = 0.72,
implying that the Taylor rule under these two chairmen satisfied the Taylor principle. On the other hand,
during the pre-Volcker era from 1960 to 1978, they find that = 0.14. The negative value for
means that the Taylor rule did not follow the Taylor principle. The Fed raised interest rates in response
to rising inflation but not enough, implying that real interest rates fell. The authors believe that the
wrong specification of the Taylor rule led to the Great Inflation of the 1970s and propose some tentative
explanations for why the Fed was so passive in that earlier era.

27
of interest.

(a) Demand Shock

(b) Output (c) Inflation

(d) Real Interest Rate (e) Nominal Interest Rate

Figure 8: Zero Lower Bound Not Binding

In the second experiment, we increase the demand shock to -5 between periods 3

to 6 (Figure 9(a)) so that the zero lower bound becomes binding between period 5 to
7 but the economy does not fall into a deflationary spiral, which on its own, is quite
remarkable since the proposed shock represents a 20 percent output contraction over a
one-year period. To provide context, output in the U.S. fell by 46 percent during the Great
Depression between 1929 and 1932. The introduction of the zero lower bound changes
the model dynamics. In particular, it implies that monetary policy has no traction when
nominal interest rates are zero and the correlation between output and real interest rates
becomes negative. In contrast to the first experiment, output declines between periods

28
4 to 6 since real interest rates surge due to lower inflation and the nominal interest rate
is stuck at zero. Deflation is only transitory however, and with no additional negative
demand shock in period 7, output surges back above the natural level. As the zero lower
bound becomes non-binding, output, inflation, and real interest rates are all put back on
a convergent path to the stable equilibrium.

(a) Demand Shock

(b) Output (c) Inflation

(d) Real Interest Rate (e) Nominal Interest Rate

Figure 9: Zero Lower Bound Binding - No Deflationary Spiral

In the third experiment, we further increase the demand shock to -6 for four consecu-
tive periods to induce a deflationary spiral characterized by sustained decline in output,
deflation, a zero lower bound binding in every period, and rising real interest rates (Fig-
ures 10(a) to 10(e)). From period 3 to 7, output declines due to increases in the real
interest rate. However, once the demand shock subsides in period 7, output returns to

29
levels very close to the natural output level which can be very deceiving to policy-makers.
If one only observes the changes in per capita gross domestic product, it looks like the
economy is getting back on track, whereas nothing could be further from the truth. When
the zero lower bound is binding and especially if it has been binding for several consec-
utive quarters, it is of utmost importance that policy-makers monitor both inflation and
output to prevent the start of a deflationary spiral.

(a) Demand Shock

(b) Output (c) Inflation

(d) Real Interest Rate (e) Nominal Interest Rate

Figure 10: Deflationary Spiral

In the previous section, we derived an analytical result showing that raising the Feds
inflation target or introducing a fiscal stimulus package can both help to prevent the
occurrence of a deflation spiral; however, once the deflation spiral has started, only fiscal
policy will get the economy out of trouble. We now quantify how large the policy response

30
has to be, either to prevent the start of a depression or to stop the depression after it
started.
We model fiscal stimulus by a positive demand shock in period 7 that follows four
consecutive negative demand shocks at -6. We find that a one-time stimulus package of
2 percent of the natural level of output is not enough to break the deflation spiral. As
informally advocated by Krugman (2008) and by Koo (2009), Congress needs to take
bold measures and pass a stimulus of at least 4 percent of the natural level of output so
that the zero lower bound ceases to be binding and the economy exits the deflation spiral
(Figures 11(a) to 11(e)).

(a) Demand Shock

(b) Output (c) Inflation

(d) Real Interest Rate (e) Nominal Interest Rate

Figure 11: Large Fiscal Stimulus Can Break a Deflationary Spiral

In our last thought experiment, we ask by how much should the Fed raise the infla-

31
tion target to prevent the occurrence of a deflationary spiral? Our results indicate that
raising the inflation target from 2 to 3 percent is enough to prevent a deflationary spiral
(Figures 12(a) to 12(e)). It is not surprising that prominent economists have argued in
favor of raising the Feds inflation target to prevent the occurrence of a deflationary spiral
(Evans, 2011; Blanchard et al., 2010). To summarize the results of our policy experiments,
it is much less costly to prevent a deflationary spiral by raising the Feds inflation target
than to fight a depression that has already started with a large increase in government
spending.

(a) Demand Shock

(b) Output (c) Inflation

(d) Real Interest Rate (e) Nominal Interest Rate

Figure 12: How Rising the Feds Inflation Target Can Prevent a Deflationary Spiral

32
8 Conclusion
In this paper, we have analyzed a standard 3-equation New Keynesian dynamic macroe-
conomic model consisting of an IS Curve, a Phillips Curve, and a Taylor Rule. We have
shown that when the model is generalized to incorporate the zero lower bound on the
nominal interest rate, it has two long-run equilibria, one stable and the other unstable.
We have demonstrated the existence of a deflationary spiral in which both output and
inflation fall without bound. We have also described policy responses that can keep an
economy out of the deflationary spiral and/or rescue it from such a spiral in case one has
already begun.
We realize that a deflationary spiral in which output falls without bound is unrealistic.
The implicit assumption of wage rigidity in this model would be hard to justify in an
economy suffering from very high unemployment. At very high rates of unemployment
wages would likely drop and, consequently, businesses would likely begin hiring again
as the economys self-correcting properties kick in. Adapting this papers model to deal
comprehensively with the deflationary spiral remains a topic for future research.

33
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36
9 Appendix: Derivation of Equilibrium Outcomes

9.1 Output and inflation when the zero lower bound is not bind-
ing; equations (7) and (8)

Our goal here is to derive expressions for output and inflation as a function of the pre-
determined inflation in period t 1 and the models deep parameters, when the zero
lower bound on the nominal interest rate is not binding.
Our first step is to use the Fisher equation (2) to replace the real interest rate in
equation (1) by rt = it t . We get the expression for nominal interest rate from the
Taylor rule in equation (5) and obtain the following relationship between t and Yt :

Yt = Yt ( (t t ) + Y (Yt Yt )) + t (21)

Next, we replace t in the previous equation by using the Phillips curve (3):

Yt = Yt ( (t1 + (Yt Yt ) + t t ) + Y (Yt Yt )) + t (22)

Note that, in the previous expression, output is the only endogenous variable at time
t. As a result, we can solve for Yt as a function of the pre-determined inflation in period
t 1 and the model parameters. After collecting the terms in Yt , we obtain:
(t t1 t ) + t
Yt = Yt + , (23)
1 + ( + Y )
which is equation (7).
Note that the output gap can be obtained from the previous expression:
(t t1 t ) + t
Yt Yt = (24)
1 + ( + Y )
To obtain an expression for inflation in period t, we substitute the output gap into the
Phillips curve (3) and use our assumption that agents have adaptive expectations. That
is, Et1 t = t1 . After collecting terms in t , we obtain the following expression for t
in terms of the parameters of the model and t1 :
(t t1 t ) + t
t = t1 + + t , (25)
1 + ( + Y )
which, when rearranged, yields equation (8).

37
9.2 Nominal interest rate when the zero lower bound is not
bindingequation (9)

The equilibrium interest rate in (9) is obtained by substituting the expression for output
gap and inflation into the Taylor rule. After some tedious algebra that involve collecting
terms and rearranging, we obtain the following expression for interest rate:
(1 + t + Y t )(t1 + t ) (1 )t t + (Y t + (1 + t ))t
it = + , (26)
1 + (t + Y t )
which is equation (9).
To solve for the inflation threshold, set it = 0 in the previous expression and solve for
the value of t1 . After tedious rearranging of terms, we obtain:

c (1 )t t (1 + t + Y t ) (t + Y t + )t
t1 t , (27)
1 + t + Y t
which is equation (11).

9.3 Output and inflation when the zero lower bound is binding
equations (14) and (15)

Our goal here is to derive expressions for output and inflation as a function of the pre-
determined inflation in period t 1 and the models parameters, when the zero lower
bound on the nominal interest rate is binding.
As before, our first step is to use the Fisher equation (2) to replace the real interest
rate in equation (1) by rt = it t . However, since it = 0, aggregate demand when the
zero lower bound is binding is given by:

Yt = Yt + (t + ) + t (28)

Next, we replace t in the previous equation by using the Phillips curve (3):

Yt = Yt (t1 + (Yt Yt ) + t + ) + t (29)

We solve for Yt as a function of the pre-determined inflation level t1 and the model
parameters:
(t1 + t + ) + t
Yt = Yt + , (30)
1

38
which is equation (14).
Note that the output gap can be obtained from the previous expression:

(t1 + t + ) + t
Yt Yt = . (31)
1

To obtain an expression for inflation in period t, we substitute the output gap into the
Phillips curve (3) and use our assumption that agents have adaptive expectations. That
is, Et1 t = t1 . After collecting terms in t , we obtain the following expression for t
in terms of the parameters of the model and t1 :

(t1 + t + ) + t
t = t1 + + t . (32)
1

After further simplification, we get

1
t = (t1 + t ) + ( + t ), (33)
1 1

which is equation (15).

39