On the Costs of Deflation : A Consumption-Based Approach

We are seeking to understand the costs of deflation. To that end, we assess the extent to which deflationary risks have surged in a selected group of European economies. Specifically, we develop a simple consumption-based asset pricing model and, based on it, we estimate a(n) (in)deflation risk premium. We find that our aggregate risk premium is correlated with a systemic financial stress indicator. The absolute values of their (time averaged) risk premia and their indices of financial development are also correlated, which is in line with what our model predicts. In addition, we estimate panel data regressions to assess the extent to which the interaction between changes in prices and nominal debts are incorporated in the risk premium. We generally find that debt-deflation terms are statistically significant. Moreover, the magnitude of the coefficients associated with the debt-deflation terms tends to be greater than those associated with inflation. This suggests that deflationary costs are comparatively greater than inflationary ones, which again is in line with our model. We rationalise this cost asymmetry with the presence of a credit constraint during deflationary episodes.Full Publication: 'http://ssrn.com/abstract=2870167' Inflation Mechanisms, Expectations and Monetary Policy