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"...If prices are falling, people will delay purchases..."

A more rational fear would be that a retailer might institute a 50% off sale next week, but this is already baked in the cake.

The normal rate of general price deflation that might be encountered is far too low for delay to be a real problem. To delay a purchase, you would need to expect a new, lower price which more than offsets the combination of time preference and consumer surplus. Highly unlikely to be significant. Plus the fact that any time and effort expended to find out what the current price and stock status is will be wasted by a delay and have to be repeated.

Regards, Don

Don: If we allow that (expected) real interest rates influence the demand for houses, cars, furniture, and other consumer durables, then it shouldn't matter whether a 1ppt increase in real interest rates is brought about by a 1ppt increase in nominal interest rates or a 1ppt increase in expected deflation. In other words, changes in expected deflation should have just the same magnitude of effect as changes in nominal interest rates. Sure, other things (like time preference) matter, but some people are always on the margin, of whether and when to purchase a new car, and a small change in real interest rates will change the decisions of those people.

Some random observations:

1. What Stephen has done is figure out a way actually to implement empirically a useful definition of deflation (or get a lot closer to it), based on the idea that durable goods should be the ones with the high interest elasticity of demand (and therefore expected deflation of durables is what matters most).

2. It seems intuitively correct to me that the more durable a good, the higher its interest elasticity of demand, other things equal. Proving this should be a simple application of standard micro theory, but I can't quite do it. Assume a cow produces one litre of milk per day, costs nothing to feed, lives for d days, then dies. Solve for the elasticity of demand for cows with respect to the rate of interest, then prove that the elasticity is greater if d is greater. The fundamental value of a cow equals the present value of its milk, and the bigger is d the greater the elasticity of the PV with respect to the rate of interest? Actually, I think it must be true, because in the limit, where d=1, buying a cow is the same as buying a litre of milk, and the PV doesn't depend on the rate of interest.

3. I was very surprised to see that there has been deflation in the US for all of the last 10 years. I was also surprised to see that deflation has been increasing in Canada, especially in the last year. Like Stephen, I think that exchange rate appreciation is the story here.

4. Is that year over year deflation Stephen? I wonder what goods the big weights are on: cars, appliances, furniture? I expect the biggest consumer durable of all, houses, is not included?

Perhaps a narrower focus may shed light on the factors influencing consumer's demand response to expected future price reductions. Computers, for example, are continually falling in price. Is it the case that such reductions reduce computer demand. Certainly this is the case at some level (as I myself have delayed a purchase for a few months for this very reason). Other forces may also be at play.

I am thinking about the marginal utility of consumption (or any consumer good) increasing with the length of time delay. As I wait to purchase a good, it becomes increasingly valuable to me to purchase it. At some point, the marginal utility of consumption today will exceed the expected future gain from potential price reductions. This will lead me to purchase the good.

So, perhaps my logic is off base... but it seems to me that deflation ought not to lead to a *permanent* reduction in aggregate demand, but a temporary one.

Trevor: I think your logic is correct (an increase in the real interest rate will cause a temporary, not a permanent fall in demand). But: that "temporary" fall might still be long enough to matter; and if a temporary decline in demand causes a recession, then income will fall, causing a further decline in demand (standard Keynesian multiplier), which causes increased deflation, which causes a further temporary decline in demand....

For econ-geeks: the Euler equation says that rate of growth of consumption over time will be a function of the difference between the real rate of interest and the rate of time preference. The long-run budget constraint says that the PV of the consumption stream equals the PV of the income stream. Putting the two together, an increase in deflation (or real interest rate) will mean a steeper path of consumption over time, but starting from a lower level of consumption today, and ending at a higher level of consumption sometime in the future. So Trevor's logic is exactly right according to standard theory. The trouble with that standard theory though, is that it's about milk, not cows (it's not about consumer durables), though I think the implications would almost certainly apply, and more strongly, to cows.

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