Ways Fiscal Policy Can Cause Inflation

1. portfolio effects. I discussed this mechanism in my last post.
   
   
2. gradual loss of confidence in financial assets. (This could be considered an example of, or a justification for, portfolio effects, but I’ll treat it as a separate mechanism.) Ultimately, a looser fiscal policy may be unsustainable. If it is truly unsustainable, then it will eventually have to be reversed, and the reversal could take the form of either a fiscal contraction or a monetary expansion (the “inflation tax”). It is hard to know in advance whether a fiscal policy is truly unsustainable, and it is also hard to anticipate how it might eventually be corrected. As a loose fiscal policy continues (which is to say, as more time passes over which it is not corrected by fiscal means), the odds of its being corrected by monetary means will tend to rise. The greater the chance of a monetary expansion, the less valuable financial assets (money and bonds) are at any given interest rate. Thus there will be a gradual shift in portfolio preferences from financial assets to real assets. If the money supply is constant (or, more generally, if it grows with productivity) and the economy is at full employment, then prices will rise gradually over a long period of time: inflation.
   
   
3. gradual loss of confidence in the pricing structure. If price setting depends on expected price levels (as in New Classical and some New Keynesian models), the gradually increasing expectation of an eventual monetary stimulus will lead to a gradual shift in the Phillips curve, thus causing prices to rise gradually for any given level of nominal aggregate demand.
   
   
4. reduced productivity growth due to crowding out. At full employment, in a closed economy, a fiscal stimulus will crowd out private investment, thus causing the capital stock to grow more slowly. As a result, productivity will grow more slowly, and real income will grow more slowly. For any given path of money supply and money demand, this means the price level will rise more quickly.
   
   
5. a naïve Taylor rule. Thus far, I’ve assumed that the money supply is exogenous and inelastic. That’s clearly unrealistic. To get slightly more realistic, suppose that monetary policy follows a Taylor rule with a fixed estimate of the “netural interest rate.” A fiscal stimulus will raise the interest rate consistent with stable prices. If monetary policy continues to follow its Taylor rule, the equilibrium inflation rate will rise.
   
   
6. inertial inflation. In practice, when we observe increases in the price level, it’s very hard (even for economists, and all the more for naïve price-setting agents) to tell whether they are one-time increases or “true” inflation. When fiscal policy produces rising prices, these will therefore tend to increase expected inflation, and the increase in expected inflation will become a self-fulfilling prophecy.
   
   People are going to complain about #6, because the self-fulfilling prophecy ultimately requires monetary accommodation. Otherwise the rising rate of price growth will eventually result in a reduced level of output, and the expectations will eventually be corrected.
   
   But here is the thing: what we really mean by higher inflation – in this era of enlightened and hawkish monetary policy – is not a permanent increase in the rate of price growth; what we mean is an increase in the rate of price growth that will be of concern to a central bank that wants to prevent a permanent increase in the rate of price growth. When people complain about fiscal policy being inflationary, they don’t mean that it actually will result in persistent inflation; they mean that it will raise a red flag at the Fed. In a perfect world where price-setting agents were perfectly rational and could perfectly discriminate temporary from permanent changes in nominal demand (and where the simple version of the IS-LM model applied), a loosening of fiscal policy would not raise such a red flag. In the real world, it does.

Channeling James Tobin

Mark Thoma (with support from Frederic Mishkin) holds with those who insist that only money can cause inflation – at least if, by inflation, one means a sustained pattern of increases in the price level. I believe that, as a formal matter, the argument is somewhat circular tautological: the conclusion is based on comparative static models in which money is the only stock variable. Fiscal policy is, almost by definition, a one-shot deal in these models, so it cannot produce a sustained pattern of change in anything.

Consider the standard closed-economy IS-LM model, as I learned it in school:

IS curve:  Y = C(tY) + I(r) + G
LM curve:  M/P = L(r, Y)

where
Y = national output
C = consumption
I = private investment
G = government spending
t = tax rate
r = interest rate
M = money stock
P = price level

Applying the standard assumption of a vertical long-run Phillips curve, we can take the growth rate of Y as exogenous for our purposes. Without loss of generality, let’s assume Y is constant.

Now, we want to ask, can the growth rate of P (otherwise known as the inflation rate) be positive if M is constant? You can see immediately from the LM curve that, if P were rising and M were constant, either r or Y would have to be changing. Otherwise the left-hand side of the equation would be falling, while the right-hand side would be constant. However, we have assumed that Y is constant, and a look at the IS curve shows that, if r is changing, then one of the other flow variables (Y, G, or t) must also be changing. But, again, we have assumed Y is constant, so unless there is a constantly changing fiscal policy (e.g., the tax rate constantly falling or government spending constantly rising), the equations won’t balance. So without money growth, you would really have to do something bizarre to get sustained inflation.

But suppose we introduce a new stock variable, call it “B” for bonds (government bonds, that is). The stock of government bonds grows as the government accumulates deficits (or falls as it accumulates surpluses). Using the “d” operator to indicate a rate of change, we can describe this process as:

dB = G – tY

For completeness, we can add yet another stock variable, the capital stock (“K”). Without loss of generality, I’m going to ignore depreciation and just say:

dK = I

In principle, private investment depends not directly on the government bond interest rate but on the required return on private capital. Let’s call this required return “s” (for “stock market return” as a mnemonic, although you should understand that it is the general required return on private capital, not just for the stock market).

In the standard IS-LM model, it was assumed that s and r were in some fixed relation, but in a world where government competes with the private sector for capital, the relation between the two returns need not be fixed. Government bonds and private capital have different characteristics – different risks, different degrees of liquidity, and so on. Investors may have a preferred proportion of holdings between the two, and when the relative supply of one asset increases, they will require some compensation for changing their proportions. Call the difference in returns between the two assets “e” (for “equity premium”) and recognize that it will depend on the relative outstanding stocks of government bonds and private capital. That gives us the following model:

Y = C(tY) + I(s) + G
M/P = L(r, Y)
dB = G – tY
dK = I(s)
s = r + e(B, K)

We now have a wedge between money growth and inflation. As the government runs a constant (sufficiently large) deficit, B increases relative to K. Therefore e(B, K) increases, and s falls relative to r. In order for Y to remain constant in the IS curve, s has to be constant in absolute terms, so this means r has to rise. In the LM curve, as r rises, with Y and M constant, P has to rise. Fiscal policy does cause sustained inflation.

Deficit Reduction and the 1990s Boom

I was an enthusiastic supporter of Bill Clinton’s 1993 deficit reduction program. I’m on record saying at the time that the Republicans were doing Clinton a favor by filibustering his stimulus bill. I believe I was right to support deficit reduction. I believe that it was important, that it had results, and that the results were better than I had expected. But was the deficit reduction program responsible for the 1990s economic boom? The short answer is no.

At least that’s the easy answer if you use standard economic theory, and for the most part, I think it’s the right answer. Throughout most of the Clinton era, the US economy was close to what the Fed believed was full employment. The Fed provided enough monetary stimulus to approach what it believed to be full employment. In the absence of deficit reduction, that stimulus would have been provided by the deficit. Or perhaps not – if the deficit had a psychological effect that was depressing the economy. In that case the Fed would have provided roughly the same stimulus that it actually did provide – to offset the depressing psychological effect of the deficit. (Remember, the Fed was already starting to push easy money long before Clinton was even elected.)

There’s no obvious reason to think that the US would have been farther from full employment if the deficit reduction bill had not passed. The reason for the boom was that full employment turned out, by the end of the decade, to be much higher and much more productive than almost anyone originally thought. Deficit reduction was – for the short run, anyhow – a demand-side policy, but the boom had little to do with demand and everything to do with supply.

Deficit reduction almost certainly did have beneficial supply-side effects, but you’ll have a hard time convincing me those effects were large enough to account for a large part of the boom. Deficit reduction was partly – perhaps largely – responsible for the boom in private investment. Without deficit reduction – that is, with lower taxes and more government spending – consumers and government would have required more of the nation’s resources, which would have left less for private investment. Any incipient investment boom would have been resisted aggressively by the Fed to avoid straining the nation’s resources.

The US would also have drawn in more resources from abroad (a larger trade deficit), so the effect of deficit reduction on private investment was far from one-for-one, but because of home bias, imperfect asset substitutability, and the large size of the US economy, a large part of the resources freed by deficit reduction must have flowed through to private investment. More private investment means a larger capital stock, which means more production from a given amount of labor, which means that some part of the boom was indeed attributable to deficit reduction. But the beneficial supply-side effect of capital deepening is a long-term phenomenon. It’s just not reasonable to expect that the effect in the first few years would be large enough to account for a large part of the boom the US experienced.

Another possible beneficial supply-side effect of deficit reduction was on price-setting. With the apparently unsustainable fiscal policy in place before deficit reduction, there was reason to fear that the Fed would eventually be forced to monetize the debt. Accordingly, there was reason to distrust the value of the dollar and reason to raise prices in anticipation of a possible eventual inflation. The Fed had to fight the tendency to raise prices, and in the process, it may have had to limit economic growth more than would otherwise have been necessary. With deficit reduction, this problem disappeared and the Fed was able to support more growth. At least, that’s a story you can tell. I can believe it was a factor, but I have a hard time believing it was responsible for a large part of the boom.

And OK, maybe you can make up some other story about how deficit reduction caused the boom, but you’re not likely to convince me. The US would have had a boom – probably a big one – even without deficit reduction. But it would not have been the same boom. In all probability, it would have been largely a boom in consumption rather than investment. That follows directly from the fact that taxes would have been lower (provided one accepts the premise that consumption rises with disposable income). And it would have been financed – to a much greater degree than it actually was – from abroad. By the end of the decade, the capital stock would have been significantly smaller than what it actually was, and the US foreign debt would have been much higher.

Which, I suppose, would not have been so terrible in 2000. But then George W. Bush got elected. After 6 more years of easy fiscal policy – new tax cuts, increased military spending, and expanded Medicare benefits – leading to more monetary tightening, which would strangle private investment and run up even larger international debt: when I think what condition the US would be in today, I’m really glad we had deep capital and a manageable foreign debt in 2000. If I had to choose between the deficit reduction program of 1993 and the economic boom of the late 1990s, I’m not sure which I would pick. Luckily, we got both.

Party Like It’s 1999

No, I’m not talking about a NASDAQ party; I’m talking about a disinflation party. The Philadelphia Fed’s Survey of Professional Forecasters reports, for the first time since the first quarter of 1999, that the median long-term (10-year) CPI inflation forecast has broken out of the 2.45% to 2.55% range – and the breakout is on the downside. (Thanks to Dave Altig of Macroblog for bringing this to my attention, whether or not that was his intention.) For the first quarter of 2007, the median is reported at 2.35% – only the second time in the history of the survey that it has been below 2.45%. (It was 2.3% in Q1 1999.) I guess the survey’s participants have come to agree with me that the Chairman’s fondness for helicopters makes him more a hawk than a dove.

The chart below shows how dramatic this breakout looks in the context of the last 8 years. (Naturally, it wouldn’t look quite so dramatic if I included the earlier data, as in this post from last August.) So break out your party hats and let’s get rip-roaring sober!

Velocity

I first encountered the Quantity Theory of Money about 26 years ago. Over the course of those 26 years, I’ve gotten a PhD in economics (macroeconomics, specifically) from a reputable university and been employed professionally as an economist, but I have to confess, I’m still having trouble understanding the Quantity Theory of Money.

For the benefit of any readers who may be unfamiliar with it, I will note that the Quantity Theory is, formally speaking, one of the simplest economic theories one is ever likely to come across. There are 4 variables:

• M = money (the quantity of money)
• V = velocity (the velocity of money)
• P = price (the general price level)
• Y = national income or output

and the theory states that

MV = PY

(“Y” is sometimes replaced by “Q” for “quantity” – actually the way I learned it – or by “T” for “transactions” – the latter being apparently a slightly different version of the theory.) The nature of my confusion may be stated succinctly: What the hell is “velocity”?

Velocity is typically defined as something like “the number of times an average dollar changes hands.” To be more precise (for the “Y” or “Q” version, but not for the “T” version), it should probably be “the number of times an average dollar changes hands for purposes of purchasing newly produced goods and services (but not including any constituent part of those goods and services that is not newly produced).”

I can kind of understand this – at least in a stylized example. If all our money took the form of dollar bills, and if we placed a check mark on a dollar bill every time we used it to purchase value added, then the velocity of money would be the number of check marks added to the average dollar bill in a year. (The “value added” concept makes things a bit difficult, though: If a hot dog vendor buys a frankfurter and a bun for $1 each, he puts check marks on each dollar he uses; if I then buy a fully assembled hot dog for $3, I have to be careful to check one of the dollars but not the other two, since only one of those dollars is being used to purchase value added.)

OK, but I have two questions: First, how is this example analogous to anything in the real world? We don’t have just one denomination of currency; we have many. Most of our transactions are electronic, anyhow. And we don’t put check marks on the currency when we use it. And even if we did, the check marks wouldn’t make any difference to anyone except maybe the people who operate printing presses on behalf of the Fed. Which leads to my second question: Why should we care? Why, in particular, should we expect this number called “velocity” to have any interesting properties, to be constant or stable or in any way predictable? Nobody has ever been able to give me a satisfactory answer to this question.

But I’ve come up with another way of thinking about the Quantity Theory, a way that does make some sense to me. Is it really, perhaps, not a theory about the circulation of money but a theory about the demand for money? Is the theory simply saying that people (and businesses and governments) choose to hold money in proportion to their intention to purchase value added? (Or perhaps, that they choose to hold money in proportion to their income, which would be equivalent because of the national income identity. Though I don’t see any reason to hold money in proportion to ones income independently of how much one intends to spend.)

If I look at the Quantity Theory as a theory about the demand for money, the “V” makes sense. Rearranging the Quantity Theory to look like a money demand equation, we have:

M/P = Y/V

In this formulation, V is simply the fraction (expressed in reciprocal form, as a “Vth,” one might say) of intended annual value added purchases that people choose to hold in real money balances. I don’t see why that fraction should be called “velocity,” but I suppose it doesn’t matter; you can call it whatever you want.

The theory is still a bit ragged around the edges: You might think people would hold money in proportion to their total intended purchases; it’s a little harder to see why money holdings would depend on value added purchases but not on resale purchases. (For example, wouldn’t I hold money in proportion to my whole $3 hot dog purchase? And wouldn’t the hot dog vendor also hold money in proportion to his $2 bun and frankfurter purchases?) But this difficulty doesn’t bother me so much, because I can see why we might expect the ratio of total purchases to value added to be roughly constant, at least in the short run.

Then, if someone wants to get more sophisticated and say something like, “The velocity of money may rise in response to rising interest rates,” I can be comfortable interpreting that to mean, “If interest rates rise, people may choose to hold a smaller fraction of their intended purchases as money balances.” Or if someone says, “The velocity of money may rise due to the increasing availability of credit cards,” I can interpret that to mean, “Credit cards reduce the need to hold money balances.” I think I’m finally learning how to translate from Monetarist-ese into English.

What is Inflation? (part 2)

Last August I argued (echoing a piece by Arthur Laffer) that recent US experience does not fit the etymological definition of the word “inflation” because nothing is really inflating. For example, the Fed is not “blowing up the balloon” by creating a lot of new money, so as to reduce the value of old money. (Laffer’s piece showed a chart of the sweep-adjusted monetary base – one measure of the Fed’s money creation – which at the time was clearly flattening out rather than accelerating.)

Recently I have been confronted with the need to deal with the subtleties in this etymological definition. In discussing the Romers’ recent paper on taxes in the comments section of Econbrowser, I asserted that “Romer & Romer also find that tax cuts increase inflation.” I was beset by (apparent) monetarists who suggested that I was “confusing price increases with inflation” and implied that inflation could not be produced merely by tax cuts because tax cuts don’t involve an increase in the money supply.

My response, in essence, was that, when tax cuts are funded by borrowing, they “inflate” the supply of dollar-denominated assets – in the form of bonds rather than money. I argued that, with more dollar-denominated assets around, the value of the dollar declines relative to goods and services, and that this process should be called “inflation.” They argued that bonds don’t inflate today’s dollar because they represent future dollars rather than current dollars. I argued that bonds are in some ways a substitute for money and therefore reduce the value of money just as an increase in nuclear power production would reduce the value of coal. If you pump up the economy by creating money substitutes, that’s just as much “inflation” as if you were to do so by creating money directly.

How do we know that bonds and money are substitutes? Because raising the price of one increases demand for the other. Raising the price of bonds (which is to say, lowering the interest rate) causes people to increase their demand for money. I gave a practical example of how they could be substitutes: checkable bond mutual funds. The availability of bonds enables me to hold my assets in the form of a checkable bond mutual fund, which I can use very much as I would use “money” in the form of bank deposits.

The ultimate issue here is money supply vs. money demand. Increases in the general price level are clearly to be considered inflation if they result from increases in the supply of money. But what if they result from decreases in the demand for money? That’s what happens when the government issues bonds, and that’s presumably the main reason that the Romers find tax cuts to be associated with inflation.

It seems to me that the definition of inflation becomes quite flimsy if you don’t allow it to take into account the demand side of the money market. In principle, the general price level can rise without bound just because of declines in the demand for money. When I was in graduate school, one occasionally heard the phrase “self-generating hyperinflation” when discussing monetary theory. Such a hyperinflation did not necessarily require any increase in the supply of money. It resulted from a loss of confidence in the value of the existing money supply. (After all, money has no fundamental value; it’s value depends entirely on individuals’ confidence that other individuals will consider it valuable.) In the event of such a self-generating hyperinflation, it would be little comfort to hear someone say, “Don’t worry; there has been no increase in the money supply; this is not inflation; it is merely price increases.”

One might still argue that the term “inflation” can’t apply unless something is “inflating.” In the case of a “self-generating hyperinflation,” the increase in the price level results from the spontaneous functioning of the market; there is nobody metaphorically “blowing up the balloon.” In the case of a budget deficit, however, there is somebody blowing up the balloon: the government is blowing bonds into the balloon, and even though their effect is arguably indirect, these bonds have the same effect (not dollar-for-dollar but in general) as blowing money into the balloon. Perhaps one could define inflation as “a rise in the general price level produced by a change in the supply of and/or demand for money induced by public policy or other factors exogenous to the money market.” (It should certainly include, for example, the effect that a new gold discovery would have on an economy that uses gold as money – or the effect of a new silver discovery on an economy that uses both gold and silver for exchange but measures prices in terms of gold.)

Don’t Just Float the Yuan

My earliest posts in this blog (see the archives from April and early May 2006) dealt largely with the subject of China’s artificially weak currency. The general thrust was that the weak-RMB policy was inefficient from a global point of view, contrary to China’s interest, and probably contrary to US interest as well despite the benefit to US consumers. Upon further thought, it seems to me that those posts stand in a somewhat ironic relation to my KNZN screen name. From a Keynesian point of view, if we take China’s other policies as given, allowing the yuan to appreciate seems like a distinctly bad idea for China and not necessarily a good one for the US.

By most accounts, the pace of capital investment in China is already so rapid as to be unhealthy. Meanwhile, despite some concerns about overheating, the inflation rate remains tame. So what would happen if China were to allow the yuan to appreciate? In terms of the components of national output, net exports would fall. There is no reason to expect a change in either consumption or government purchases. This means that China’s monetary authorities would face a choice: either push easy money to encourage increased private investment, or let national income fall (relative to its path under the current regime). If national income were to fall, standard Phillips curve theory suggests that the inflation rate would fall as well, possibly pushing China into an unpleasant deflation. Those possibilities don’t sound particularly pleasant.

There is also the possibility that “standard” Phillips curve theory doesn’t apply in this case. That is, China’s Phillips curve may be flat in its current range, so the result of an appreciation would be lower output at the same inflation rate. A flat Phillips curve is essentially a free lunch, so by advising China to allow appreciation without encouraging more rapid investment, we would be advising them to pass up the free lunch. Alternatively, maybe the Phillips curve is vertical, in which case deflation becomes the only alternative to more rapid investment in the case of an appreciation.

The US, on the other hand, is by most accounts (though not by mine) already near (if not at or above) full employment. By increasing net exports (which is to say, decreasing net imports), a stronger yuan would force the Fed to raise interest rates to discourage private investment, which is already not as strong as one might hope. (I’m assuming that the Fed agrees with the consensus and not with me, and since the US Phillips curve seems to be fairly flat right now, it will be a long time before the Fed – and the consensus – realizes its error. Alternatively, you can just assume that the consensus is right.)

So a good Keynesian ought not to advocate a mere floating of the yuan (unless of course that good Keynesian disagrees with the consensus that investment in China is currently too rapid). For China, a good Keynesian ought primarily to advocate a fiscal stimulus – lower taxes or more government spending, perhaps a publicly financed health insurance system that would reduce the need for precautionary saving by individuals. Once the fiscal stimulus is a done deal, it will hopefully be obvious to the Chinese that the currency needs to appreciate.

Does Romer & Romer mean that tax cuts are generally good for growth?

U.S. federal tax returns are due tomorrow, and the subject seems to be on the mind of bloggers. Greg Mankiw cites a recent study by Christina and David Romer, which finds a strong inverse association between exogenous tax changes and economic output:

Our baseline specification suggests that an exogenous tax increase of one percent of GDP lowers real GDP by roughly three percent.

Greg cites the paper without comment, leaving readers to draw their own conclusions, and it appears that many readers have drawn conclusions that may not be warranted (and in some cases, clearly are not warranted) by the paper. The difficulty arises from taking the above finding out of context while failing to consider another important finding about the response to a tax increase:

…inflation appears to fall substantially. The point estimates show the impact reaching 2.2 percentage points after ten quarters, then spiking down to 3.1 percentage points in quarter 11 before returning to 2.2 percentage points in quarter 12.

There are two things to notice about this inflation impact. First, it goes in the opposite direction from what would be expected based on a supply-side explanation of the impact of tax changes: if tax increases reduced supply, the inflation rate should rise, not fall. Second, if we take the point estimates seriously, the effect on inflation is huge. Anyone expecting a tax cut to increase growth is going to have to take into account the fact that Ben Bernanke is also likely to read this study – and we all know what Ben is likely to do when he expects inflation.

To put it bluntly, Romer & Romer’s results are quite consistent with a world in which any future tax cut (unless it is offset by a spending cut) is likely to reduce growth, once the expected monetary policy response is taken into account. Their results do not allow us to decompose the tax impact into a supply-side effect and a demand-side effect, but they are at least consistent with the complete absence of a supply-side effect, whereas they are not consistent with the absence of a demand-side effect. If there is no supply-side effect, then there is no change in the economy’s potential growth rate in the short run. Therefore there will be no change in the Fed’s target level of output. Therefore (barring a liquidity trap) the Fed will act to fully offset the short-run impact of tax changes on output. And to do so, in response to a tax cut, the Fed will have to raise interest rates, increasing financing costs for businesses and discouraging investment. Unless the marginal propensity to consume is zero or the Fed makes a mistake, the path of investment will end up lower than what it would have been in the absence of the tax cut. Therefore the capital stock will end up lower, and long-run growth will end up lower.

As I said, the results do not allow us to rule out a supply-side effect, and it’s quite possible that the supply-side effect will be enough to offset the damage to growth from the Fed’s response to the demand-side effect. But I wouldn’t be in too much of a hurry to cite this study as a reason to extend the Bush tax cuts.

A Lactic Phenomenon

The price of milk is always and everywhere a lactic phenomenon…except when it isn’t. Clearly, if there is a bovine plague that constricts the supply of milk, causing the price to rise, that is indeed a lactic phenomenon. You couldn’t explain it without knowing which specific commodity was involved. But suppose the price of milk rises – along with the price of everything else – because of an increase in the supply of money (or, for that matter, a decrease in the demand for money). That phenomenon has nothing to do specifically with milk, and it is therefore not, in any fundamental sense, a lactic phenomenon.

So here’s my question: Isn’t the converse also true? Suppose our bovine plague hits. And suppose the monetary authorities ignore the plague and just go about their business comme si de rien n'était. The price of milk will rise; the price of everything else will stay more or less the same; so the average price level – for any average that includes milk – will rise.* That conforms to the generally used (though perhaps not etymologically correct) definition of inflation. But it is clearly not a monetary phenomenon; it’s…well…a lactic phenomenon.

Now you may point out that the effect on the general price level will be tiny, so who really cares? But suppose, instead of milk, I consider oil, or housing services, or even tobacco. Let’s try oil. Suppose a cartel decides to constrict the supply of oil, and suppose the monetary response is again passive (as per my earlier footnote, no change in the quantity of money relative to its previously intended path)**. The price of oil – and everything that contains oil or one of its substitutes – will rise relative to the price of other things – such as money – that don’t contain oil. To put it differently – and tellingly, I think – the price of non-energy-intensive goods and services will fall relative to the price of energy-intensive ones. Since many goods and services have significant energy content, and money is perhaps one of the least energy-intensive goods in the economy, its price will fall, which is to say, the general price level (denominated, as per convention, in terms of money) will rise. According to most observers, that would be inflation, but I insist, it is not a monetary phenomenon; it is…hmm…an “unctual” phenomenon, perhaps.

Granted, if the prices of oil, tobacco, and housing services all rise at the same time, as they have recently, we have reason to suspect that there is a truly monetary phenomenon involved. I will note, however, that I am still in the camp that thinks the US is experiencing more an unctu-domo-tobaccic phenomenon than a monetary one. I can point to market-specific issues in the markets for oil, shelter, and tobacco, and I will also point out that the dispersion of price changes across goods and services has been higher than usual. Do we really believe that the general price level is rising (relative to its ideal path) and that there are specific problems with those markets whose products are falling in price?




*Yes, I know, I’m glossing over a lot of general equilibrium issues here. For one thing, I’m ignoring the shape of the money supply function. But I think my general point goes through for any reasonable money supply function: so let’s just say that it’s perfectly inelastic and that “comme si de rien n'était” means to create exactly the same quantity of money they would have created in the absence of a plague. For another thing, I’m ignoring the spillovers from the milk industry to other industries. For example, the laid off milkmaids could be re-employed as, say, gas station attendants, and thereby reduce the price of full-serve gasoline, partly offsetting the effect of the milk price increase on the general price level. The key word there is “partly.” Cows are capital, and capital is being destroyed, so the general productive capacity of the economy declines. In aggregate, the supply of other goods and services has declined relative to the supply of money.

**But come to think of it, what should the money supply response be to a downward shift in the supply of oil? Shouldn’t the economy be shifting resources from more energy-intensive industries to less energy-intensive ones? Doesn’t this mean it should shift resources into the money-producing industry and produce more money rather than less?

Bad Luck

As Bruce Bartlett will tell you, the conventional wisdom among Keynesians during the 1970s was that the rising inflation rate in the US during that decade was primarily the result of a string of unlucky events – oil shocks, a bad anchovy harvest, and so on. Among Keynesians today, the conventional wisdom is that their predecessors were wrong and that the rising inflation rate during the 1970s resulted from excessively loose policy. The problem is, from a Keynesian point of view, today’s conventional wisdom doesn’t make quantitative sense.

Under the Keynesian paradigm, a loose policy can be defined as one that tends to push the unemployment rate below the non-accelerating inflation rate of unemployment (NAIRU), so that inflation will tend to accelerate. Conversely, a tight policy can be defined as one that tends to push the unemployment rate above the NAIRU, so that inflation will tend to decelerate. Whether the unemployment rate is in “loose” or “tight” territory, the economy will be subject to shocks (bad luck – or good luck), which may cause the inflation rate to do something else, but these shocks cannot be blamed on (or credited to) policy. (Also, there may be shocks in the policy transmission process that prevent the unemployment rate from reaching its intended level in the first place, but these aren’t the type of shocks that people have in mind when discussing the 1970s.)

The average unemployment rate for the US during the 1970s was 6.2%. Until the mid-1990s, conventional estimates put the NAIRU at about 6%. Using the conventional linear approximation to the Phillips curve, this means that policy, on average, managed to push the unemployment rate to a level that should have resulted in a slight decline in the inflation rate. On average, policy was tight, not loose.

If anything, this simple analysis underestimates the extent to which policy was tight. The 6% NAIRU estimate came with full benefit of hindsight. An estimate produced using data available during the mid-70s would put the NAIRU somewhat lower. So if we describe policy in terms of its actual intentions, rather than the results that might have been anticipated with benefit of hindsight, it was more than a little tight.

This is not to say that policymakers (meaning the Fed) necessarily acted appropriately during the 1970s. Perhaps, in the interest of restoring the credibility they lost during the Johnson-Nixon years, they should subsequently have been even tighter than they were. Perhaps high inflation is just bad and should have been met aggressively at every turn, even when it was not the result of recent policy. But leaving these normative issues aside, it’s hard (at least if we accept the Keynesian paradigm) to see how, in the absence of considerable bad luck, the inflation rate at the end of the 1970s could have been so much higher than it was at the beginning. Did anyone notice a black cat on Constitution Avenue?