Deflation and internal-devaluation might also work...

Paul Krugman is arguing about the desirability and plausibility of external devaluation or depreciation over internal devaluation that the first one is easy and quick to achieve instead of cutting nominal wages and prices through the latter. Both are the ways of cutting wage cost, lower prices relative to the nominal exchange rate and increase demand for exports. In depreciation the economy tries to cut real wages with inflation, and, lower cost of production and prices relative to the nominal exchange rate. Inflation also increases the nominal exchange rate. Such a policy aims two things, lower cost of production and prices, and higher nominal exchange rate too. But to achieve depreciation it is important that inflation increase which might not work in the liquidity trap when people save more in expectation of higher future prices because of expansionary policies. But, when savings go up, inflation fails to materialise and instead turn to disinflation or deflation which increases the problem of liquidity trap by lowering prices and interest rate. Even very large amount of money fails to increase inflation. Lower demand increases the relative supply and put a downward pressure on prices in the liquidity trap. However, if inflation goes up it would lower domestic demand due to lower real wages. Therefore, depreciation in liquidity trap world might not work, and moreover inflation and real wage cuts would increase external demand at the cost of domestic demand. In internal devaluation also the economy tries to reduce nominal wages and prices relative to the nominal exchange rate to increase export demand which would also hurt domestic demand, but wages are mostly sticky in the short-run which economists consider responsible for adjustment to store demand. The wage rigidity points to adjustment in other cost, profits and prices to increase external demand which might not be as rigid as wages because all wages are consumed, like low interest rates. But, in the liquidity trap or at the zero lower bound the adjustment cannot be continued without increasing expected inflation which aggravates savings and liquidity-trap by reducing domestic demand and growth. Much of the developed world is going through the liquidity trap and expansionary policies are unable to increase inflation and depreciation. Lose policies have failed to increase inflation and depreciation, but expected inflation and savings have worsened the spending, demand and growth. Therefore, lack of depreciation has not increased external demand and expected inflation has also lowered domestic demand. However, if the policy-makers commit deflation with lose money-supply because lower interest-rate would increase investment and supply, and lower the prices, they might be able to increase both domestic and external demand without increasing inflation, inflationary-expectations, depreciation and nominal exchange rate. It would work same like depreciation by lowering prices and increase the real exchange rate to increase export demand. Krugman should think about the difficulty the Western-world is facing to increase inflation when deflation is more imminent and more money-supply is not pushing inflation up, but rather increasing supply and lowering prices by lowering the borrowing cost. In such a condition deflation could be used as a strategy to increase real exchange rate and external demand. Lower prices would also increase domestic demand. When deflation could help achieve higher real wages and higher exchange rate and domestic and external demand, both, then “why the policy-makers are trying to increase inflation, which would increase external demand by increasing the nominal exchange-rate, but would decrease real wages and internal-demand, when they might choose to increase both by internal devaluation...? Lower prices or inflation would increase real-wages and domestic-demand and higher real exchange rate due to deflation could also increase external-demand...

Wages in Japan...

Japan under Shinzo Abe is still trying to target inflation when unemployment has reached a very low level and the economy is waiting to see rise in wages and inflation in the core or manufactured goods segment when food and fuel inflation failed to respond due to low population growth rate and good supply-side. Japan is now targeting core-inflation with food since oil-prices have come down to half and are not a problem. But low unemployment-rate may signal a labour supply shortage which would increase demand for wages, and, could increase wage cost and inflation. Nonetheless, if Japan increases the borrowing cost it would be able to increase inflation in a proportion of increase in interest-rates. Too low interest rates for more than two decades have removed the constraint imposed by higher interest rates on the supply-side.  Food and fuel prices that generally result in inflation in a country are very low in Japan and supply is not a problem, therefore they do not show demand pressures and inflation. Japan has invested heavily in food and fuel supply.  But, low population growth rate might constrain labour-supply and may poke wages and inflation in the retail price of manufactured products because then the market would compete for labour. Japan’s open economy is too responsible for low inflation. Foreign supply of goods and services has also kept prices and inflation low. In short Japan’s supply side is too good that the economy failed to generate inflation, but very low unemployment would help increase wages which Abe wants to increase inflation. Abe is pleading to the Capitalists that they should increase wages to increase demand and inflation, but they are ignoring because that would increase cost and reduce profits when there is a downward pressure on the price-level and inflation due to low demand. It would reduce their pricing-power during slowdown. Japan is actually doing the same the other countries do in a slowdown... It is trying to cut real interest rate and wages by increasing inflation in order to increase investment spending, but due to inflation-targeting people are reluctant to spend because they are expecting inflation ahead and are saving more for the future which has actually put the economy in the liquidity-trap. Low spending (consumption and investment) has depressed prices and interest-rate pushing the economy in the liquidity-trap. To overcome liquidity-trap inflation targeting is a bad strategy because it would increase savings. Liquidity-trap is mainly an expectation problem; if people expect inflation they would save more for future, but if they expect deflation and higher real wages they would consume more because lower prices would increase demand. And in this situation if lower prices increase demand relative to supply then the economy might also be able to push inflation up in the future. So far the country has tried to increase investment spending and inflation, but low demand due to low real wages has failed to attract supply. Abe wants to increase inflation for the Capitalist and investment spending, but he may also try to increase consumption spending which might also increase demand and inflation. But, this time the economy must commit deflation and not inflation which could increase real-wages and demand. Japan might commit zero interest rate and more fiscal spending as long as deflation persists.  Abe can increase wages or real wages without the Capitalists’ help using the monetary and fiscal policies by committing deflation... He should commit that lose money-supply might also be deflationary when supply increases relative to demand against the long held opinion that more money-supply would only increase demand relative to supply and would stoke inflation. Lose money-supply might also increase supply and lower the price-level. More money-supply may also increase supply by lowering interest rate cost which may also decrease the price-level, and, increase real-wages, demand and growth...

Lower inflation and inflationary-expectations in the US...

Interest-rate depends upon the money-supply, the price level and expectation of changes in it, because of the price-stability objective of the monetary-policy or the central-banks. They manage money-supply to adjust interest-rate and demand/supply which jointly determines the price-level or inflation. But, interest-rate in turn is also determined by inflation and inflationary expectations, both short-run and long-run. Higher inflation and inflationary expectations also make the central-banks fine-tune money-supply and interest-rate. Normally central-banks job is to ensure price-stability, but when growth-rate is tumbling it might set higher-inflation-targets, because it is a sign of higher demand/supply and economic-activity. Generally, booms and high growth-rates coincide with higher prices and interest-rate. Nonetheless, busts and slow-downs in the economic-activity and growth-rate calls for lower interest-rates, but to cut interest-rates during down-turn it is important to tighten during higher inflation otherwise it would feed bubbles by increasing the gap between nominal and real prices of assets because of inflation. The fear that lose money-supply and interest-rate might create asset-price-bubbles in the US is baseless since inflation is too low. Moreover, the fear of risky investment because of too low rates is again overdone since banks lend only after assuring feasibility of the project. Nevertheless, low interest-rate on retirement-funds also depends on inflation and inflationary expectation, and, low interest-rate would also mean that inflation in future could remain low which means higher real-interest rates, and the argument that pension funds might lose because of low rates may also be overblown because it would also signal that inflation could remain low in the future so that less savings would be needed. In the US economy low inflation is responsible for low interest-rates which may push the case for more money-supply since it has been a year now when the Fed ended its QE program and inflation is still below the official target of 2%. The effect of QE is fading since inflationary expectations are still low with oil from the Shale-revolution, which had put the expansion of the US economy in shambles many times before. Lower oil-price expectations in the economy has kept inflationary expectations and interest rate low,  which is likely to stay because the US is now a big oil producing country. Most of the prior recessions in the US economy were associated with oil-price booms and inflation. Lower oil-prices are a major contributor to low inflation and inflationary expectations after Shale. Higher oil-prices in the future would also make high-cost shale-exploration more viable, and, thereby more production and supply leading to further low oil prices, inflation expectations and interest-rate.