Sunday, May 29, 2011

Why Not Inflation?

I advocate a slow, steady growth path for money expenditures on final goods and services. I favor a growth rate equal to the trend growth rate of potential income--the productive capacity of the economy. The result should be a trend growth rate of money incomes equal to the trend growth rate of real income and a price level for final goods and services that is stable on average.

The Federal Reserve, however, favors having slow, steady price inflation. In their view, the CPI should rise about 2 percent a year from where it happens to be. If there is some error, or as they like to describe it, surprise, perhaps causing the price level to rise 4% in a year, then it should just increase at a 2 percent rate from there. In other words, the growth path for the CPI is unachored, but the growth rate is kept rising at 2 percent.

Leaving aside the unanchored path, why not have persistent inflation?

I believe that persistent inflation leads to the phenomenon of explicit or implicit cost of living pay increases. These cause no problem if the economy always remains in equilibrium. Equilibrium money wages increase with the increase in equlibrium real wages plus the inflation rate.

But suppose there is an adverse aggregate supply shock. With money expenditure targeting, the growth path of nominal incomes remains unchanged. The adverse aggregate supply shock causes the price level to move to a higher growth path, and as that adjustment occurs, the inflation rate is higher. Real incomes, including real wages, shift to a lower growth path. This reflects the reduction in productivity.

If the supply shock is permanent, then the price level remains stable at a higher level. If, on the other hand, the supply shock is reversed, then there would be tempory deflation and the price level would revert to its initial value.

Suppose, however, that workers demand "cost of living increases." More importantly, suppose employers believe that they must provide such increases in order to keep and continue to recruit good workers. While the experience of employers and employees is that cost of living increases generally work smoothly, with each firm able to pass on the added costs in the form of higher prices along with growing real sales, with an adverse aggregate supply shock, this is not true.

If employers seek to increase money wages to compensate for the higher inflation, and money expenditures remain on target, the resulting decrease in real expenditures will cause reduction in production and employment. While an adverse aggregate supply shock inevitably has adverse effects on production and might also adversely impact employment because of a need to reallocate labor, trying to avoid the reduced real income by raising money wages and prices is impossible.

Recently, there has been some concern that the run up in food and energy prices might be reflected in rapid increases in wages. If that occurs, it will begin a wage and price spiral. To avoid this, some argue that the Fed should tighten monetary policy to prevent the increase in food and energy prices. A rather unpleasant prospect with unemployment remaining near double digits.

But if the Fed has a policy of having the purchasing power of money drop continuously, and raising wages to compensate for that inflation generally has no adverse impact, should a tendency for employers and employees to raise wages due to a "higher cost of living" be a surprise? Further, with the unachored growth path for the CPI, an error that leads to an excess supply of money and an increase in aggregate demand will result in a higher equilibrium growth path of prices and wages. Here again, compensating workers for the higher cost of living is appropriate.

Consider instead a world where prices are usually stable, and when they rise to a higher level, this implies an adverse aggregate supply shock and any effort to raise money incomes and prices to offset this will have adverse consequences. Here the lesson is that employers are not in a position to compensate employees for higher prices with higher wages.

In my view, what employers and employees should learn is that inflation and higher prices is the result of slow growth or even decreases in productivity. The "answer" is efforts to enhance productivity--for example, working more or harder.

Presumably, if all markets clear like the stock market, there is no problem. Wages will only rise with the trend rate of inflation or shocks to aggregate demand. They won't rise when there is an adverse shock to aggregate supply. Unfortunately, I don't think that is the world in which we live.


  1. Mr. Woolsey, a couple of questions:

    (1) Can you conceivably describe a truly aggregate supply shock? That is, leaving aside Armageddon scenarios, can you provide some kind of credible real-world example all global production of everything can decrease simultaneously?

    (2) Is there any reason to expect that steady increasing monetary expenditures don't come at the cost of steadily diminishing future consumption, and if so, why?

  2. 1. Cap and Trade

    2. I am quite certain that steadily increasing money expenditures do not result in steadily decreasing future consumption. Why? It is difficult to know where to start.
    I think you are confused about something. Apparently, I was not clear enough.

  3. Would it be fair to say that this is the common misunderstanding between a general price rise due to monetary expansion and a relative price change due to a shift in supply and demand for some good(s)?

  4. To me, a relative price change due to a shift in supply or demand for some good is too partial of an analysis. If the demand for gasoline rises, how was this funded? Where did demand decrease? And so, the macro implication is that there is a decrease in demand and price somewhere else that tends to offset the increase in the price of gasoline. (And the offsetting shifts in "q" implies unchanged output at first pass.

    One of the key implications of the monetary disequilibrium/equilibrium approach is that if the demand for gasoline rises and the demand for "nothing" falls, then money is being ignored--there was a decrease in the demand to hold money. If the quantity of money adjusts to remain equal to the demand to hold money, there is still no inflationary impact.

    When there is a shift in the supply for a particular good, this is not necessarily going to happen. The is a drought in Iowa, the supply of corn decreases, and the price of corn rises and the quantity of corn falls. The macro implication is a higher price level and a lower level of output.

    The lower level of output implies less real income. Money being a normal good, this implies a lower demand to hold money. If the quantity of money is reduced to match the demand, then the prices of all goods must fall, including corn. But this is a decrease from corn's already increased price. The price level returns to its initial level and the prices of all other goods and services drop. This includes resource prices like labor.

    Money expenditures targeting just says--no. Don't try to contract the quantity of money to match a decrease in demand to to lower real income. Keep money expenditures on a stable growth path. The price of corn rises and the quantity falls. The price level is higher and real output is lower. And that is it.

  5. I wouldn't call policy a "supply shock." Sorry, I meant explicitly economic events. I guess destructive political whims are "Armageddon scenarios" in my mind.

    You effectively dodged my second question, so I'll give you another try: Other than magick, where is all this money coming from, when you consistently grow the money supply?

    In other words, there are people out there in the world who feel that money represents more than a policy willing it to exist. You can't divorce money from value in the real, physical world (not even with a good abstract argument).

    So the question I'm really asking you is why you think it's possible to increase an economy's value by reducing the value of the unit that measures value! (Whoosh, what a mouthful!) If growth is important, and you intertemporally substitute future growth for current growth, why is that not a cost?

    Seems like a free lunch to me, but maybe I'm just out there.

  6. I think public policies create aggregate supply shocks frequently, however, I don't really think of supply shocks as being general reductions in the supply of everything. On the contrary, I am usually thinking of decreases in the supplies of particular things, like oil or corn. Other things being equal (which is plausible enough,)aggregate output falls and the price level rises. In my view, it is undesirable for monetary institutions to do anything about either change. If a monetary institution does something to reverse the impact on the price level (which is certainly possible,) or temporarily offset the decrease in output (which I think is also possible,) these should count against those institutions.

    As for you other point, I still have no idea why you think that current spending on output leads to less future consumption. Are you ignoring current spending on capital goods? I favor slow steady growth in spending on output, which would include spending on consumer goods and services, but also spending on capital goods and even government goods and services. Real future consumption depends on the future labor force, capital stock and technology--future real income. I am not advocating that nominal consumption continuously grow out of a given level of money income. It is rather than nominal output, nominal income, nominal consumption, and nominal investment all grow together. And, that interest rates be at whatever level is necessary to keep saving and investment equal.

    The "free lunch" is correcting monetary disequilibrium by changing the nominal quantity of money rather than prices and wages. This allows for more real output and more real income. If prices are perfectly flexible, there is no such free lunch. But I don't that is the case in the real world.

    It is difficult to explain better unless you will be more clear about what you have in mind. What is worrying you? What sort of monetary institutions do you favor?

    I do think that nominal values can all increase at pretty much any rate without every having to come back down. Why not?

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