Friday, April 20, 2007

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.)

Labels: , , , , ,

19 Comments:

Blogger Gabriel Mihalache said...

I don't think you need to go to all that trouble of linking inflation, the technical term, the loss of purchasing power of money, with the physical term "inflation".

You're right... both money supply and money demand matters.

The issue is, of course, what's money.

Bonds are pretty liquid these days. Maybe I'm wrong, but at a theoretical level I can we can suggest that maybe they should be included in a M4 or something like that?

And then there's an issue of magnitude. I don't think you can get any major movements in the price level because of money demand. None of the interesting inflation cases can be accounted by ignoring money supply.

Fri Apr 20, 03:05:00 PM EDT  
Anonymous mvpy said...

What about endogenous money? That is, we have an increase in the money supply without any increase in the base (via more lending etc).
After all, this is the big issue whether money causes output or vice versa.
Also, knzn, what do you think of the "fiscal theory of the price level". This would indeed predict a rise in the price level if the government increased debt. With this theory, inflation is a fiscal phenomenon; basically, prices rise and fall so as the keep a stable gov debt ratio. Adherents to this theory claimed that the fall in inflation in the nineties was a result of, well, a rise in gov surpluses. So prices fell to maintain a stable *real* debt GDP ratio. I have to say, I find this theory a bit bizarre, but theres enough really smart guys (like John Cochrane) who think this is big deal.
(As my name suggests, Im not a big fan, however).

Fri Apr 20, 04:39:00 PM EDT  
Blogger knzn said...

“None of the interesting inflation cases can be accounted by ignoring money supply.” I think that’s because of the way central banks have responded to events that affect money demand. For example, if you take fiscal loosening as an example of an event that reduces money demand, in all cases I can think of, either the central bank accommodates (e.g. US in the 60s) and gets blamed for the subsequent inflation, or they fight the loosening tooth and claw (e.g. US in the 80s) and you don’t get the inflation. The problem is, we seldom, if ever, observe situations where a change in money demand was met with a neutral money supply policy.

So I do think you can get “major movements in the price level because of money demand;” it’s just that they’re typically obscured by supply events that either offset them or reinforce them. In terms of the quantity theory of money, MV=PY, if you ignore V and look at the actual paths of M and PY, you’re going to end up with a lot of anomalies. For example, the US disinflation in the early 80s should have been even faster on the basis of M alone.

The original context in which I brought up the issue was how the central bank would respond to a fiscal loosening (tax cut). If it expects prices to rise, as the Romers’ results suggest it should, then it is likely to tighten, and you won’t get most of the output effect that’s found in the Romers’ results. I suppose the central bank could say, “This is not really inflation; this is just price increases; so we don’t have to tighten.” Then you’ll get perhaps most of the output effect, plus an increase in the measured inflation rate, which I suppose would not be such a terrible thing. The trick, though, is for the central bank to maintain confidence in its ultimate unwillingness to monetize the debt – which might be hard to do in the face of observed increases in the price level. If people start to lose confidence in money, you’re faced with a money demand issue that might be a real problem (not to mention an aggregate supply issue that might be an even bigger problem).

Fri Apr 20, 05:04:00 PM EDT  
Blogger knzn said...

I think a fiscal loosening would increase the supply of endogenous money (banks more eager to make loans given the higher interest rates) and probably increase the demand as well (more demand for interest bearing forms of endogenous money; less demand for non-interest-bearing forms; but overall demand probably higher due to higher nominal income). In that case we would observe increases in money stock measures, which might be misinterpreted as exogenous money supply shocks and then blamed for the inflation. (And people will say, “Yes, this really is inflation; see, the money supply is going up!” confusing cause and effect.)

The fiscal theory of the price level is very interesting, and I think it does have some relevance, though I think it would be quite a stretch to credit the 90s disinflation to fiscal tightening (particularly since the previous episode of disinflation occurred during a period of fiscal loosening). I do think fiscal policy makes some difference in people’s confidence in the value of money, but I suspect the response is nonlinear, and I doubt the US has ever gotten to the point where the response became steep enough to be interesting. I’ve been suggesting that fiscal policy reduces demand for (base) money by the much more mundane mechanism of increasing the supply of money-substitutes.

Fri Apr 20, 05:59:00 PM EDT  
Blogger Gabriel Mihalache said...

Huh... this discussion gives me a headache, as all "verbal" macro discussions do.

The reason is that we want to "talk through" a phenomenon determined by a large number of agents acting at once, some of the fiscal or monetary authorities.

We want to do this sequentially: X happened so Y did Z so we see B. This is why the discussion hasn't progressed very much since the late 19th century, really.

For better or worse, I don't think we can elucidate this without models...

Sat Apr 21, 03:31:00 PM EDT  
Blogger knzn said...

I don’t think I need a model, though, to make the empirical point that, historically, money supply has seldom if ever been passive to changes in money demand. And that’s why we don’t observe major price events that appear to be due solely to money demand changes.

Also, I think my point about tax cuts comes out of any Keynesian model with the standard features, e.g. IS, LM, accelerationist Phillips curve, and a Taylor rule for monetary policy. (Actually, I guess LM and the Taylor rule are redundant to each other, so forget about the LM curve.) Of course I’m not going to write out all the microfoundations for these things – that’s somebody else’s job. (Now that I think about it, you have to be able to turn off the Taylor rule; my point was based on the premise that the Taylor rule does not generally apply in Romer & Romer’s sample but would for any contemplated future tax cut.) And one can probably rewrite the standard Keynesian model as a monetarist model by making the velocity of money depend on the interest rate.

I should note, though, to match Romer and Romer’s results, it’s important for the IS curve to include a large accelerator effect, where private investment depends positively on output. If you want a supply-side effect, you could maybe make private investment also depend negatively on taxes, but my original point was that you don’t need such an effect to match their results.

The real modeling would come in if I try to make a quantitative point: that you would need an implausibly large supply-side effect in order for a tax cut (without spending offset) to increase growth in the final equilibrium. I never actually tried to make that point. (And to make the point for an open economy, I’d have to start estimating actual supply-side effects instead of talking about what’s plausible, because it’s clearly plausible that the supply-side effect could be large enough for growth to rise if that growth is foreign-financed.)

Sun Apr 22, 05:32:00 AM EDT  
Anonymous Anonymous said...

福~
「朵
語‧,最一件事,就。好,你西.............................................................................................................
..................

Thu Apr 02, 09:55:00 AM EDT  
Anonymous Anonymous said...

酒店喝酒,禮服店,酒店小姐,酒店領檯,便服店,鋼琴酒吧,酒店兼職,酒店兼差,酒店打工,伴唱小姐,暑假打工,酒店上班,酒店兼職,ktv酒店,酒店,酒店公關,酒店兼差,酒店上班,酒店打工,禮服酒店,禮服店,酒店小姐,酒店兼差,暑假打工,酒店經紀,台北酒店,禮服店 ,酒店小姐,酒店經紀,酒店兼差,寒假打工,酒店小姐,台北酒店,禮服店 ,酒店小姐,酒店經紀,酒店兼差,暑假打工,酒店小姐,台北酒店,禮服店 ,酒店小姐,酒店經紀,酒店兼差,寒假打工,台北酒店,禮服店 ,酒店小姐,酒店經紀,酒店兼差,暑假打工,酒店小姐,台北酒店,禮服店 ,酒店小姐,酒店兼差,暑假打工,酒店小姐,台北酒店,禮服店 ,酒店小姐,酒店經紀,酒店兼差,寒假打工,酒店小姐,台北酒店,禮服店 ,酒店小姐,酒店經紀,酒店兼差,暑假打工,酒店小姐,台北酒店,禮服店 ,酒店小姐,酒店經紀,酒店兼差,寒假打工,酒店小姐,台北酒店,禮服店 ,酒店小姐,酒店經紀,酒店兼差,暑假打工,酒店小姐,禮服店 ,酒店小姐,酒店經紀,酒店兼差,寒假打工,酒店小姐,禮服店 ,酒店小姐,酒店經紀,酒店兼差,暑假打工,酒店小姐,禮服店 ,酒店小姐,酒店經紀,酒店兼差,寒假打工,酒店小姐,禮服店 ,酒店小姐,酒店經紀,酒店兼差,暑假打工,酒店小姐,酒店傳播,酒店經紀人,酒店,酒店,酒店,酒店 ,禮服店 , 酒店小姐,酒店經紀,酒店兼差,暑假打工,招待所,酒店小姐,酒店兼差,寒假打工,酒店上班,暑假打工,酒店公關,酒店兼職,禮服店 , 酒店小姐 ,酒店經紀 ,酒店兼差,暑假打工,酒店,酒店,酒店經紀,酒店領檯 ,禮服店 ,酒店小姐 ,酒店經紀 ,酒店兼差,暑假打工, 酒店上班,禮服店 ,酒店小姐 ,酒店經紀 ,酒店兼差,暑假打工, 酒店上班,禮服店 ,酒店小姐 ,酒店經紀 ,酒店兼差,暑假打工, 酒店上班,酒店經紀

Tue Apr 21, 06:47:00 PM EDT  
Blogger Talia.float said...

Bought the Tennis Racquet is important, exercise can reduce the harm, especially for the wrist injury. But the good of Tennis Racket in general in the real prices are more expensive, so a lot of websites now have cheap tennis racquet,tennis racquet discount,cheap tennis racket,discount Tennis Racket .

Tue May 19, 12:07:00 AM EDT  
Blogger how to buy air shoes said...

Some new style Puma Speed is in fashion this year. chaussure puma is Puma Shoes in french. Many france like seach “chaussure sport” by the internet when they need buy the Puma shoes or buy the nike max shoes.The information age is really convenient. By the way ,the puma CAT is really good chaussures puma ,don’t forget buy the puma mens shoes and nike air max ltd by the internet when you need them . Do you know Nike Air Shoes is a best Air Shoes .

Spring is coming, and how to choose the polo shirts is the main concern of many people. ralph lauren polo shirts is a classic type and reliable. ed hardy clothing is more in line with the aesthetic ideas of young people, so many young people filled with a variety of ed hardy clothes in their wardrobes. New style ed hardy womens shirt match the new style ed hardy sunglasses , it is a good idea.
Do you think this season is not for ugg boots ? maybe yes .but this season is best time that can buy the cheap ugg boots. Many sellers are selling discounted. Do not miss . Please view my blog and fc2 blog .thank you .

Tue May 19, 06:04:00 AM EDT  
Blogger raul said...

Some new style Puma Speed is in fashion this year. chaussure puma is Puma Shoes in french. Many france like seach “chaussure sport” by the internet when they need buy the Puma shoes or buy the nike max shoes.The information age is really convenient. By the way ,the puma CAT is really good chaussures puma ,don’t forget buy the puma mens shoes and nike air max ltd by the internet when you need them . Do you know Nike Air Shoes is a best Air Shoes .

Spring is coming, and how to choose the polo shirts is the main concern of many people. ralph lauren polo shirts is a classic type and reliable. ed hardy clothing is more in line with the aesthetic ideas of young people, so many young people filled with a variety of ed hardy clothes in their wardrobes. New style ed hardy womens shirt match the new style ed hardy sunglasses , it is a good idea.
Do you think this season is not for ugg boots ? maybe yes .but this season is best time that can buy the cheap ugg boots. Many sellers are selling discounted. Do not miss . Please view my blog and fc2 blog .thank you .

Wed May 20, 03:24:00 AM EDT  
Blogger wow power leveling said...

cheap wow gold buy wow power leveling my wow gold cheapest wow power leveling
replica replica rolex
CHEAP wow power level
BUY power leveling
replica rolex replica
cheap lotro gold
replica rolex
CHEAPEST power leveling
cheap rs gold l

Tue Jun 09, 10:44:00 PM EDT  
Blogger poston said...

wholesale gemstone jewelry
wholesale crystal jewelry
crystal wholesale
rock crystal


crystal jewelry
wholesale jewelry
jewelry wholesale
cheap jewelry

Sun Sep 27, 11:05:00 PM EDT  
Blogger Adi said...

Oes Tsetnoc one of the ways in which we can learn seo besides Mengembalikan Jati Diri Bangsa. By participating in the Oes Tsetnoc or Mengembalikan Jati Diri Bangsa we can improve our seo skills. To find more information about Oest Tsetnoc please visit my Oes Tsetnoc pages. And to find more information about Mengembalikan Jati Diri Bangsa please visit my Mengembalikan Jati Diri Bangsa pages. Thank you So much.
Oes Tsetnoc | Semangat Mengembalikan Jati Diri Bangsa

Tue Nov 24, 10:28:00 PM EST  
Anonymous Tag Heuer Watches said...

Rolex Watches Rolex Watches
Tag Heuer Watches Tag Heuer Watches
rolex replica rolex replica
replica rolex replica rolex
rolex replica watches rolex replica watches
replica rolex watches replica rolex watches
Tag Heuer Tag Heuer
replica Tag Heuer replica Tag Heuer
Tag Heuer replica Tag Heuer replica
rolex rolex
rolex air king rolex air king
rolex datejust rolex datejust
rolex day date rolex day date
rolex daytona rolex daytona
rolex gmt rolex gmt
rolex submariner rolex submariner
rolex yachtmaster rolex yachtmaster
rolex air king watches rolex air king watches
rolex datejust watches rolex datejust watches
rolex day date watches rolex day date watches
rolex daytona watches rolex daytona watches
rolex gmt watches rolex gmt watches
rolex submariner watches rolex submariner watches
rolex yachtmaster watches rolex yachtmaster watches

Mon Dec 21, 04:46:00 AM EST  
Blogger Jimmy Wang said...

I had never see a blog batter than this blog, I like this blog very very much.By the way, do you like my products: solar street lights, street lights, street lighting, street lamps, ball valves, butterfly valves, butterfly valve handles, check valves, sanitary fittings, butterfly valve handles, butterfly valve handles, street light, butterfly valve handles butterfly valve handles, street lamp, solar street light, ball valve, butterfly valve, check valve

Wed Mar 24, 05:24:00 AM EDT  
Anonymous Anonymous said...

Jimmy Choo Boots
|Jimmy Choo Patent leather sandals
|Jimmy Choo Patent leather sandals|Jimmy Choo Patent leather sandals
|Jimmy Choo Patent leather sandals
Christian Louboutin Bat Girl 100 shoes
Christian Louboutin black leather Monty thong sandals

Wed Sep 22, 12:10:00 PM EDT  
Anonymous فيس بوك said...

this is very helpful thank you`

Wed Nov 10, 03:42:00 AM EST  
Anonymous Moncler Outlet Online said...

We are dedicated to delivering the most recent and greatest high quality Louboutin Heels along with other artist at Cheap Ugg Uk.With this broad variety of Christian louboutin Heels and the beautiful Moncler Outlet and Moncler Outlet Online at our Moncler Online Shop. now gets the ladies' favorite. New Best Hair Straightener from our finest locks Straightener on the Chi Hair Straightene anything you have to produce Ugg uk sale that great bohemian style.

Fri Aug 26, 03:02:00 AM EDT  

Post a Comment

Links to this post:

Create a Link

<< Home