Virtually all economists agree that disinflation and deflation are caused by a shortage of dollars in the economy. The majority agree that such deflation is accompanied by a rise in unemployment. If inflation is too many dollars chasing too few goods, then deflation is too few dollars chasing too few goods. As a side effect some of those goods are never caught. No one buys them, their producers lay off workers and unemployment rises...See here and here also.
The economy is being dragged down by the spiral of ever lower inflation. As banks and businesses see inflation fall, it only increases their incentive to sit on the cash they have. As I mentioned before, if we reach outright deflation then they can earn a profit simply by stockpiling money in vault. Every year as prices fall the money locked in that vault would become more and more valuable.
However, money locked in a vault does nothing to support economic growth. It does not fund new investments, new workers or new products. Without that base of new investment or new spending, prices fall further, goods are discounted more deeply and the deflation spiral worsens. We could power out of such a spiral by raising inflation expectations. The Fed could promise that any decline in prices today would be met by an equal rise in prices tomorrow. Any business considering sitting on its cash would know that know that this is a losing proposition. What it gains by taking advantage of disinflation today, it will lose when exposed to re-inflation tomorrow.
Nov 12, 2010
Since additional fiscal stimulus is out of the question, Fed Chairman Bernanke is planning another round of monetary policy action. It's rather weak tea, but basically they're going to try and push up the inflation rate a bit by buying a huge mess of treasury bonds. It's the functional equivalent of printing some money. I think this is an area where people's intuitions (printing money bad! strong dollar good!) can lead them astray. The usual suspects are howling about "debasing the dollar," but Karl Smith gives a great explanation of why we need this sort of thing, in the context of arguing that Bernanke is not doing enough: