Given that wage changes tend to precede inflation/deflation, this is an indicator of the deflation to come via the general prices in the economy. Deflation is being drawn as yet another parallel between the Great Depression and now, as well as memories of the recent decade long stagnation of Japan. What is of interest to us is that deflation is seen as the predominant reason why the great depression and Japanese recession were somewhat prolonged. Inflation is said to 'grease the wheels of monetary policy'.This is a direct corollary of fisher equation, where i=r+pi (e), where i is nominal interest rate, r real interest rate and pi (e) expected inflation. If pi (e) is negative, and i is very low (approaching 0 in the Fed's case), then the real rate is very high. Simple IS-LM analysis will show a reduction in expected inflation translated to a leftward shift of the IS curve. 
IS1=Y(i0-pi1(e),G)
Note that when pi1(e)
In normal times inflation is stablised in Central Banks by raising interest rates when ex ante inflation is above target, and reducing interest rates when ex ante inflation is below target. However in current conditions interest rates have unfortunately gone to the 0 lower bound. If this is the case, are there ways the Central bank can counter the surge in deflation and unemployment? Welcome to the liquidity trap!
The Liquidity Trap
Note that these problems tend to become catastrophic when nominal interest rates are well below the 'neutral rate of interest', and approach the 0 lower bound. At this stage monetary policy is 'pushing on a string', and increasing the quantity of High Powered Money does not directly encourage or influence banks to lend and consumers and firms to borrow. If anything, excess reserves are increasing due to Banks requiring excess reserves as a safety net to repay debt, to raise capital, and from pure credit rationing to consumers and firms. This means that the money supply is not increasing to the same extent as High Powered Money, and the money multiplier, which measures the increase in money supply due to a $1 increase in HP money, is now less than 1.
The plight of monetary policy brings us to open-market operations (OMOs). As OMOs function via bond purchases or sales, when interest rates are so low, money and bonds become perfect substitutes. What happens is that the purchasing of treasury bills by the Central Bank and the corresponding injection of reserves into banks has no real effects, as reserves are risk-free assets that are comparable with bonds. In normal times, OMOs increase the ratio of money to bonds, hence increasing the price of bonds in terms of money. This is the inverse of the interest rate, and hence expansionary OMOs reduce interest rates. What's happening now is that the price for bonds does not necessarily increase when the Central bank transacts in the bond market, and consequently the yield is unchanged. With constant yield, there is no change in interest rates, and so Monetary Policy loses complete effect. This is the theory of 'liquidity preference', put forward by Keynes to show how a 'liquidity trap' constrains lending as banks are willing to sit on a pile of reserves at such low rates, as they are more liquid and earn the same yield as bonds.
Another way to view and understand the liquidity trap is that it represents the 0 lower nominal bound. Expansionary monetary policy is offset by i) a money multiplier that is marginally negative and ii) falling velocity of money. In particular, the velocity of money is indeterminate at the 0 lower bound, and is mitigating the increase in money supply. The Quantity theory approach to monetary policy is to suggest that if Py=MV, where P is the price level, y is real income, M is nominal money stock, and V is velocity of money, then any increases in M are offset by reductions in V. This is because V is positively related to nominal interest rates, and tends to fall more as interest rates approach 0:
A dropping velocity of money indicates that the expanding HP money is not leading to an effective increase in money supply, as money demand within the banking system increases and is fully satiated at a 0 interest rate. That is, a reduction in velocity is equivalent to an increase in money demand, as banks demand for cash balances rises and there is no need to circulate money balances to pursue higher yielding bonds when bond yields have dropped to 0. The IS-LM model illustrates the money demand effect, as any increase in money supply is satiated at a 0 interest rate, with no effect on equilibrium interest rate and output.
The increased money demand is due to the increased risk in securitising markets and the circular crisis of falling market and funding liquidity due to system-wide deleveraging.Using what we have just learnt, deflation is the consequence of money demand outpacing growth in the money supply. In light of constant interest rates, this requires falling prices to maintain money market equilibrium. This gives a monetary interpretation of why deflation is occurring, apart from the more conventional explanation of the Phillips Curve, which interprets any short-term increase in unemployment above the natural rate as reducing inflation. Thus we have the dual problems of deflation creating leftward shifts of the IS curve, and the low interest rates creating the famous 'liquidity trap' situation of ineffective Monetary policy experienced in the Great Depression and particularly in Japan. Bernanke has nevertheless done much research on the Japan liquidity trap, and has looked into various Monetary approaches. One such approach is to try to diversify Fed balance sheets, by, for example, taking in various different securities apart from short-term Treasury securities. By taking different securities, it is attempting to increase the price of these securities and reduce yields, essentially driving down the cost of funding in particular security markets. To some extent, the recent expansion of the Fed is in the form of taking such securities as collateral for short-term lending to various institutions, noted as the 'flooding of liquidity', where without such 'flooding', the fed funds rate would be higher than otherwise. Yet such an invitation to different securities is almost equivalent to the Fed being a competing financial intermediary, rather than a Bank separated from the commercial world, with the sole purpose of regulating credit growth. Not only that, but it would entail a significant degree of risk, yet another aspect of the commercial world a Central bank should stay well out of. Yet the modification to the 'lender of last resort' function in recent months has headed in such a direction, and Krugman calls this the 'Bernanke policy twist'.
Another unconventional monetary approach in 0 lower bound conditions is to perhaps invest in longer-term treasury bonds, which results in a long-term structure of low interest rates. The idea is that, if you cannot lower yields on short-term treasury securities (which are essentially 0), then it may be worth reducing yields on long-term bonds, trying to create low interest rates for a prolonged period of time. This will also help in raising inflationary expectations and hence reducing the real rate, which will help ease credit conditions and induce consumption and investment.
At present these are the main types of unconventional open-market operations at present. Whether these are having effect is debateable, and is the subject of my next post: Monetary Policy Rules?
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