Real theories of the business cycle predict that the public would feel worse off if inflation rose (due to supply shocks.) In contrast, demand-side models predict that an unanticipated fall in inflation would make the public feel worse off. That’s because demand shocks reduce inflation by shifting AD to the left, which also reduces real GDP, and hence real national income. Even though inflation falls, NGDP growth falls even more rapidly. With low demand for investment goods, real interest rates also tend to fall.
The following article suggests that the public regards this as a demand-side recession, where lower inflation actually seems like higher inflation:
WASHINGTON (AP) — Inflation spooked the nation in the early 1980s. It surged and kept rising until it topped 13 percent.
These days, inflation is much lower. Yet to many Americans, it feels worse now. And for a good reason: Their income has been even flatter than inflation.
Back in the ’80’s, the money people made typically more than made up for high inflation. In 1981, banks would pay nearly 16 percent on a six-month CD. And workers typically got pay raises to match their higher living costs.
Over the 12 months that ended in February, consumer prices increased just 2.1 percent. Yet wages for many people have risen even less — if they’re not actually frozen.
Social Security recipients have gone two straight years with no increase in benefits. Money market rates? You need a magnifying glass to find them. . .
The median U.S. inflation-adjusted household income — wages and investment income — fell to $49,777 in 2009, the most recent year for which figures are available, the Census Bureau says. That was 0.7 percent less than in 2008.
Incomes probably dipped last year to $49,650, estimates Lynn Reaser, chief economist at Point Loma Nazarene University in San Diego and a board member of the National Association for Business Economics. That would mark a 0.3 percent drop from 2009. And incomes are likely to fall again this year — to $49,300, she says.
Just to be clear, I am referring to the entire three year long recession and sluggish recovery, not the last couple months. During recent months there has been a modest supply shock, due to events in Libya and then more recently in Japan. It’s too soon to know the severity of these two shocks.
In the comment sections of posts there is a disturbing tendency of people to make the following mistake. They notice that monetary stimulus often raises commodity prices more than other prices. They notice that supply shocks often raise commodity prices more than other prices. They infer that monetary stimulus can cause a supply shock. In fact, monetary stimulus raises commodity prices if and only if it raises expected future output. There is no other mechanism. In contrast, supply shocks reduce expected future output. Don’t confuse AS and AD shocks.
Update 3/20/11: I obviously meant “real commodity prices” when I referred to commodity prices in the preceding paragraph. Several commenters pointed out that one could find theoretical mechanisms by which QE could raise commodity prices and reduce AS. In macroeconomics one can find theoretical arguments for almost any proposition. In my reply to Statsguy I provided numerous reasons why I don’t think those contractionary mechanisms would be empirically important.