Sunday, April 15, 2007

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?

19 Comments:

Blogger Gabriel Mihalache said...

Huh... If supply for one commodity changes then we'd expect for ALL prices to change, not the price of that commodity.

That price will rise, others will decrease.

We can't say what the result will be, in the (inflation) index, with weighting and so on, unless we know how elastic is the demand for various goods.

It's ambiguous.

Sun Apr 15, 11:59:00 AM EDT  
Blogger Gabriel Mihalache said...

P.S. You also seem to use the wiggle room between relative prices and nominal prices...

Sun Apr 15, 12:03:00 PM EDT  
Blogger knzn said...

Technically it’s ambiguous, but you’re going to have to come up with a pretty odd example (or an odd price index) to get the average price level to fall when the supply of a particular good falls. Anyhow, my point doesn’t depend on what specifically happens to average price level; it’s just that changes in the supply of one good can (and generally will) affect the average price level; if you tell me the average price level will fall, then I’ll just go the other direction and take an example where the supply of the good increases.

I’m not sure what you mean by “wiggle room.”

Sun Apr 15, 04:11:00 PM EDT  
Blogger knzn said...

Think of money as just another good, rather than the numeraire good. My point is that the value of money is going to be affected by all kinds of things which have nothing directly to do with money and which therefore can’t reasonably considered monetary phenomena. Therefore, if you define inflation as “something that reduces the value of money,” inflation is not always a monetary phenomenon.

Sun Apr 15, 04:32:00 PM EDT  
Anonymous Anonymous said...

MV = PY
If Y goes down and M and V stay the same then P should rise, right? So if output drops then the Fed should reduce the money supply. This was the received wisdom in the late '20s and early '30s, right?

Sun Apr 15, 08:16:00 PM EDT  
Anonymous Anonymous said...

I was kinda laughing about thinking about money as "just another good", when the lowly penny and nickel are going to be gone within a year or two.

Gresham's Law will show you gabriel how the price of a commodity can change the elasticity function.

If a nickel is worth 9 cents will it continue to circulate at face value?

Allenm

Tue Apr 17, 07:55:00 PM EDT  
Blogger Gabriel Mihalache said...

I expect that if one price rises, others to drop. Maybe not to perfectly offset it all the time.

This refrains the loss of purchasing power from individual price changes to come anywhere near the levels required for non-monetary accounting of contemporary inflation.

With Cobb-Douglas preferences (generating two demand functions), two goods, Walras' Law and a weighted price index you get a constant price index whatever the price for the first good. Maybe I'm doing something wrong, though.

Wed Apr 18, 01:27:00 PM EDT  
Blogger knzn said...

Hmm, that seems intuitively wrong to me. Of course, my intuition can be expected to have done something wrong, but I still don’t believe that. As a technical point, how can there be a price index if there are only two goods? Doesn’t one have to be the numeraire?

I’ll concede that, say, 2 percentage points of CPI inflation in the US are a monetary phenomenon, and I would consider that a good use of monetary policy – indeed less grease on the wheels than I would consider optimal. But that extra half percentage point or so that troubles the Fed – that I feel comfortable attributing to market-specific issues (which, mind you, are for quite important markets – energy and housing, in particular).

The traditional monetarist formulation is MV=PY. You seem to be trying to tell me that Y doesn’t really matter. (Because surely, for example, a constriction in the supply of energy does reduce potential output by a non-trivial amount in the short run.)

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