Monday, April 15, 2013

Deflation: Why it is not happening?

After reading Paul Krugman's "Missing Deflation" I started wondering why prices have not declined in view of the dull recovery at both sides of the Atlantic. After some thought I think I might have a few answers.

First of all, the prices are sticky! There are contracts and imperfect competition. A firm might be bounded by a contract, the price is subject to that contract and thus cannot be adjusted. In case of imperfect competitions, firms of the same sector or from the same geographical region might have formed a trust- alternatively, some short of silent (or not) coordination scheme- and thus have agreed not to reduce their prices. These factors of rigidity are, more or less, influential mostly during short periods; a five-yeared period is not what you would call "short", but they conserve some explanatory value.

Secondly, in a fundamental general equilibrium model, i.e. labor market, AS-AD and money market, an adverse shock in demand is dealt with a contraction in supply. Naively stated, if prices were that elastic recessions would have never existed. If firms were able to tread a negative demand shock by setting an adequately lower price quantity produced would remain unchanged. Since recessions have always been a part of reality, quantity produced falls with demand and as a result price changes are not necessary. This argument offers some explanation for the realization of a non-negative course of the CPI.

Thirdly, oil prices- energy prices, in general, if you wish- constitute an additional burden over the cost incorporated in any business activity. Costs such as those of transportation, production, machinery maintenance, packaging, material and services influx (which also incorporate the above when they were being "produced") and buildings (electricity, maintenance, cleaning etc.) are all affected by the price of oil. Please note that the activities deriving the above mentioned costs comprise the use of hydrocarbon others to smaller and other to a larger extent. The cost argument can also explain why CPI changes excluding energy prices have also been positive the last five years following the 2008 crash. It is also an alarming reasoning for what will follow the imminent decrease in oil prices... 

That is all I could think of the last few days.