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On the Costs of Deflation: A Consumption-Based Approach

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  • García-Verdú Santiago
  • Ramos Francia Manuel

Abstract

Our interest is to understand the costs of deflation. Thus, we explore the extent to which deflationary risks have surged in a selected set of European economies. To that end, 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 and a systemic financial stress indicator correlate negatively. The absolute values of their (time-averaged) risk premiums and their financial development indices correlate as well. Both relations are in line with our model. In addition, we estimate panel data regressions to explore the extent to which changes in the price and debt levels, are priced in by the (in)deflation risk premium. We generally find that deflation terms contributes negatively to such a premium and inflation positively. The magnitudes of the coefficients associated with deflation tend to be greater, compared to those associated with inflation. This suggests that deflationary costs are relatively larger than inflationary ones. We rationalize this cost asymmetry with the presence of a credit constraint under deflationary periods.

Suggested Citation

  • García-Verdú Santiago & Ramos Francia Manuel, 2018. "On the Costs of Deflation: A Consumption-Based Approach," Working Papers 2018-20, Banco de México.
    • Handle: RePEc:bdm:wpaper:2018-20
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    More about this item

    Keywords

    Consumption-based asset pricing; Inflation; Deflation; Inflation Risk Premium; Deflation Risk Premium; Eurozone;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation

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