Why Did Large-scale Deflation Occur? What Did It Bring About?: From Hong Kong's Experiences in the First Half of the 2000s

This article examines why large-scale deflation occurred in Hong Kong in the first half of the 2000s and what costs it brought about. During the period, the consumer price index fell at an annual rate of nearly 4% (over 5% in terms of GDP deflator). The substantial fall is unparalleled in the history of the postwar world economy, and provides a valuable case study to identify causes and consequences of deflation. One interesting characteristic is that, despite the substantial fall in prices, economic growth rate was high for several years. Hong Kong's experiences illustrate that deflation does not always coincide with recession, and that economic recovery can be achieved even during a prolonged deflationary period. Our empirical analysis shows that external shocks, not domestic shocks, were a major factor that caused the substantial fall in domestic prices in Hong Kong. In particular, falls in export and import prices due to the strong Hong Kong dollar had a major effect on the fall in domestic prices. The deflation kept real wages at a high level, thus raising the unemployment rate. However, unlike Japan, Hong Kong experienced practically no debt deflation, so that there were only minor turbulences in its financial market. As a result, Hong Kong achieved relatively high economic growth despite the substantial deflation. Despite its China's special administrative region, the Hong Kong's experiences have important lessons for the other economies on what are causes and consequences of large-scale deflation.