Before World War II, deflation—a falling aggregate price level—was almost as common as inflation. (We introduced deflation in Chapter 21.) In fact, the U.S. consumer price index on the eve of World War II was 30% lower than it had been in 1920. After World War II, inflation became the norm in all countries. But in the 1990s, deflation reappeared in Japan and proved difficult to reverse. Concerns about potential deflation played a crucial role in U.S. monetary policy in the early 2000s and again in the aftermath of the 2008 financial crisis.

Why is deflation a problem? And why is it hard to end?

Deflation, like inflation, produces both winners and losers—but in the opposite direction. Due to the falling price level, a dollar in the future has a higher real value than a dollar today. So lenders, who are owed money, gain under deflation because the real value of borrowers’ payments increases. Borrowers lose because the real burden of their debt rises.

In a famous analysis at the beginning of the Great Depression, Irving Fisher (who first analyzed the Fisher effect of expected inflation on interest rates, described in Chapter 25) claimed that the effects of deflation on borrowers and lenders can worsen an economic slump. Deflation, in effect, takes real resources away from borrowers and redistributes them to lenders.

Fisher argued that borrowers, who lose from deflation, are typically short of cash and will be forced to cut their spending sharply when their debt burden rises. Lenders, however, are unlikely to increase spending sharply when the values of the loans they own rise. The overall effect, said Fisher, is that deflation reduces aggregate demand, deepening an economic slump, which, in a vicious circle, may lead to further deflation. The effect of deflation in reducing aggregate demand, known as debt deflation, probably played a significant role in the Great Depression.

Like expected inflation, expected deflation affects the nominal interest rate. Look back at Figure 25-7, which demonstrated how expected inflation affects the equilibrium interest rate. In Figure 25-7, the equilibrium nominal interest rate is 4% if the expected inflation rate is 0%. Clearly, if the expected inflation rate is −3%—if the public expects deflation at 3% per year—the equilibrium nominal interest rate will be 1%.

But what would happen if the expected rate of inflation is −5%? Would the nominal interest rate fall to −1%, in which lenders are paying borrowers 1% on their debt? No. Nobody would lend money at a negative nominal rate of interest, because they could do better by simply holding cash. This illustrates what economists call the zero bound on the nominal interest rate: it cannot go below zero.

This zero bound can limit the effectiveness of monetary policy. Suppose the economy is depressed, with output below potential output and the unemployment rate above the natural rate. Normally the central bank can respond by cutting interest rates so as to increase aggregate demand. If the nominal interest rate is already zero, however, the central bank cannot push it down any further. Banks refuse to lend and consumers and firms refuse to spend because, with a negative inflation rate and a 0% nominal interest rate, holding cash yields a positive real return: with falling prices, a given amount of cash buys more over time. Any further increases in the monetary base will either be held in bank vaults or held as cash by individuals and firms, without being spent.

A situation in which conventional monetary policy to fight a slump—cutting interest rates—can’t be used because nominal interest rates are up against the zero bound is known as a liquidity trap. A liquidity trap can occur whenever there is a sharp reduction in demand for loanable funds—which is exactly what happened during the Great Depression. Figure 31-14 shows the interest rate on short-term U.S. government debt from 1920 to 2014. As you can see, from 1933 until World War II brought a full economic recovery, the U.S. economy was either close to or up against the zero bound. After World War II, when inflation became the norm around the world, the zero bound largely vanished as a problem, as the public came to expect inflation rather than deflation.

However, the recent history of the Japanese economy, shown in Figure 31-15, provides a modern illustration of the problem of deflation and the liquidity trap. Japan experienced a huge boom in the prices of both stocks and real estate in the late 1980s, then saw both bubbles burst. The result was a prolonged period of economic stagnation, the so-called Lost Decades, which gradually reduced the inflation rate and eventually led to persistent deflation.

In an effort to fight the weakness of the economy, the Bank of Japan—the equivalent of the Federal Reserve—repeatedly cut interest rates. Eventually, it arrived at the ZIRP: the zero interest rate policy. The call money rate, the equivalent of the U.S. federal funds rate, was literally set equal to zero. Because the economy was still depressed, it would have been desirable to cut interest rates even further. But that wasn’t possible: Japan was up against the zero bound.

In the aftermath of the 2008 financial crisis, the world’s most important central banks—the U.S. Federal Reserve and the European Central Bank—found themselves facing much the same problems the Bank of Japan had faced since the 1990s: the economies they were trying to manage remained depressed despite policy interest rates close to zero, and inflation was persistently below target. As of 2014, neither the United States nor the euro area was experiencing actual deflation, but as the following Economics in Action describes, Europe was getting alarmingly close.