Prof. Mankiw reminds us of the difference between the Great Deflation of the 1930s and the current recession. Let me sum him up shortly.
He says that the two effects of falling prices on economy:
(1) Falling prices bring the economy to the equilibrium
(a) An increase in M/P
For any given supply of money M, a lower price level implies higher real money balances M/P. An increase in real money balances leads to higher income.
(b) The Pigou effect
Falling prices increase real money balances and consumers should feel wealthier and spend more. This increase in consumer spending should cause higher income.
(2) Falling prices don't bring the economy to the equilibrium
(a) Debt-deflation theory
The unanticipated changes in the price level redistribute wealth between debtors and creditors: unexpected deflation enriches creditors and impoverishes debtors.
This redistribution of wealth affects spending on goods and services. In response to the redistribution from debtors to creditors, debtors spend less and creditors spend more. It seems reasonable to assume that debtors have higher propensities to spend than creditors, and then debtors reduce their spending by more than creditors raise theirs. The net effect is a reduction in spending and lower national income.
(b) An decrease in expected inflation
People's expectation that the price level will fall in the future leads to a negative expected inflation, πe. The real interest rate is now higher at any given nominal interest rate.
(Real interest rate) = (nominal interest rate) - (expected inflation)
This increase in the real interest rate depresses planned investment spending and national income because when firms come to expect deflation they become reluctant to borrow to buy investment goods because they believe they will have to repay these loans later in more valuable dollars.
The fall in income reduces the demand for money, and this reduces the nominal interest rate that equilibrates the money market. The nominal interest rate falls by less than the expected deflation, so the real interest rate rises.
Mankiw says that most economists believe that the mistakes that led to the Great Depression are unlikely to be repeated. Is that true?
I don't think so. Even though the Great Depression is unlikely to be repeated again, we cannot say that our economy is also unlikely to undergo a recession.
As Mankiw says, many economists believe that the Great Deflation was responsible for the depth and length of the Depression and the presence of a falling money supply. Right, but can the Fed always control money supply? That's the question. Remember that the Fed can control only base money(currency+deposit), but not money supply.
How the Fed should control or affect money supply is a basic question in monetary macroeconomics left at our hands.
Greg Mankiw's Blog: 2008 = 1929?