Does Deflation Increase Aggregate Demand?

Brad DeLong gives Paul Krugman the microphone:

The New Deal and the Depression: Interesting stuff. I agree that the NIRA might have raised the structural rate of unemployment – but the economy got nowhere near the structural level of unemployment during the NIRA period, so what difference could that have made? What really puzzles me, though, is the assertion that wage and price rigidity created by the New Deal aborted the natural recovery process. Through what channel could price flexibility have helped? The US spent most of the 30s pretty much up against the zero bound, with interest rates well below 1 percent. A fall in the price level would have had the same effect as an increase in the monetary base – that is, no effect at all – except for the slight wealth effect of rising real balances. And even this slight effect could easily have been outweighed by debt deflation. You just have to bear in mind that this was, um, the Great Depression – normal rules about monetary policy did not apply. And the same goes for any possible role of price flexibility.

Yes, the liquidity trap as in a horizontal LM curve. The debt deflation aspect is further discussed here:

As he notes falling money wages and price levels will lead to redistributions of income – firstly, from wage-earners to non-wage earners and, secondly, from debtors to creditors, the net effect of which would be the reduction in the economy-wide marginal propensity to consume … The income redistribution effect was taken up by Michal Kalecki … in an imperfect competition model. Specifically, if money wages decline, then the mark-up between prices and wages would increase (i.e. increasing “degree of monopoly” in Kalecki’s language). This would result in a redistribution of income from wage-earner to profit-earners. If profit-earners have a lower propensity to consume than wage-earners (a reasonable assumption given social reality), then the average marginal propensity to consume in the economy declines and thus aggregate demand declines. Thus, far from being stabilizing, the reduction in money wages in a situation of unemployment can lead to reductions in aggregate demand and thus more unemployment. The second effect was already expressed in Keynes (1931) and in Irving Fisher (1933) and is known as the “Debt-Deflation Effect”. Effectively, if prices decline, then the real value of private wealth increases, which implies that the liabilities of debtors and assets of creditors increase in real terms. Again, complying to social reality, debtors have a higher marginal propensity to consume relative to creditors (which might help explain how they became debtors in the first place!), consequently, there is a reallocation of real wealth from debtors to creditors and thus the aggregate marginal propensity to consume declines. The result of price flexibility in situations of unemployment, then, is once again a decline in consumption demand and thus a further reduction in aggregate demand and employment. This Debt-Deflation Effect was given a central role by James Tobin (1980) …

In other words, a redistribution of income from individuals with a lower propensity to save to individuals with a higher propensity to save would shift the IS curve inwards. And if the LM curve is flat, aggregate demand would decline.

Update: Daniel Gross reads my comment on what Bryan Caplan wrote and emails me this:

Is the sheer a-historicity of it. Roosevelt scared investors and businessmen? Did he scare them as much as, oh, Stalin, who controlled one of the world’s largest economies and was expanding his influence? or as much as Mussolini? Or as much as the fascist government of Japan? Or as much as Hitler, who was buys confiscating property of Jewish investors and businessmen? On a comparative basis, the U.S. was certainly the country in the 1930s that was the most hospitable to private investment and capital formation. Economic history unfolds in real history, not in some imagined world. The New Deal was a success if only because it kept the U.S. from sliding into the type of horrific fascism that infected half of Europe and the pathetic weakness that affected the other half.

As we noted, investment demand increased substantially from 1932 to 1937. Daniel Gross mocks the idea that FDR scared investors – at least relative to the fear investors may have had seeing what was going on in Germany, Italy, Japan, and/or Russia.