Question

Lars Svensson, a former Princeton professor and deputy governor of the Swedish central bank, proclaimed that when an economy is at risk of falling into deflation, central bankers should be "responsibly irresponsible" with monetary expansion policies. What does this mean, and how does it relate to the monetary transmission mechanisms?

Short answer

As a result of being "responsibly irresponsible," central banks may provide temporary but powerful inflationary policies, which will raise inflation expectations, magnify aggregate demand, and easily lift the economy out of deflation.

Step-by-step solution

Step 1. Concept of Deflation 

Deflation occurs when the overall price level declines and the economy's inflation rate is negative.

Step 2. Explanation

When the economy is in a deflationary state, the rate of inflation falls below zero, causing interest rates to rise and the cost of capital to rise as well. An increase in the cost of capital leads to lower consumption and investment through interest rate channels, adding to the deflationary pressure. In addition, the short-term nominal interest rate has reached zero, rendering traditional interest rate policy ineffective.

As a result of being "responsibly irresponsible," central banks may provide temporary but powerful inflationary policies, which will raise inflation expectations, magnify aggregate demand, and easily lift the economy out of deflation.