neutral inflation/real inflation

4th March 2019 Off By binary
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Over at Econlog, I have a new post pushing back against the view that inflation is caused by “global factors” such as economic slack. I point out that the UK and Switzerland have faced the same global factors since 1971, but have had vastly different inflation rates, due to vastly different monetary policies.

This confusion is actually a symptom of a deeper problem, the tendency of many economists and other pundits to view inflation as a sort of “real phenomenon.” At a fundamental level, inflation is nothing more than a change in the value of the medium of account, sort of like switching from using feet to using meters. It doesn’t change the size of objects being measured. People in Turkey and Argentina have adjusted to inflation that is higher than in India, and Indians have adjusted to inflation that is higher than in the UK, and the Brits have adjusted to inflation that is higher than in Switzerland.

In the 1980s, Americans easily adjusted to 4% inflation, as their wages rose faster than today. The economy was not “overheating”.

In the short run, unexpected changes in inflation can have real effects on output due to wage/price stickiness, nominal debt contracts, money illusion, etc. (It’s as if the size of the objects being measured changed as a result of switching from feet to meters.) The mistake many people make is to work backwards from these short run real effects and assume they actually cause the inflation (or deflation)!

No, no, no, a thousand times no! An overheating economy does not cause inflation. Economic growth is deflationary. Rather, higher than expected inflation can cause an economy to overheat. But you can also have high inflation without any overheating at all, indeed even with lots of “slack”.

Inflation is caused by monetary policy, and that monetary inflation might or might not have a wide range of real effects associated with it, depending on all sorts of contingencies. If I read that Argentina has 20% inflation, I don’t immediately think “overheating”, I think “printing money to pay the bills.”

Many New Keynesians rely on models where inflation is associated with some sort of overheating. In fairness, those models generally have some sort of natural rate component, and include expectations of inflation. They are still “reasoning from a price change”, and thus highly flawed, but at least they understand that money is neutral in the long run and that economic slack doesn’t explain long run changes in inflation.

Old Keynesian models are even worse (and AFAIK) this also applies to MMT. They simply assume that inflation is not a problem as along as there is economic slack. Milton Friedman once said that in 200 years we’d merely gone one derivative beyond Hume. Unlike the monetarists and New Keynesians, lots of pundits and economists still haven’t even incorporated the first derivative into their models.

And while looking at changes in inflation is better than looking at the absolute level of inflation, it’s still not good enough. It’s still reasoning from a price change. We need to focus on changes in NGDP growth, which may or may not have real effects, depending on all sorts of factors. But at least with a model of:

Monetary policy —> NGDP —> inflation/unemployment/RGDP

we are on the right track.

If you begin with:

Economic slack —> inflation/deflation

then you aren’t even on the right track.

PS. Consider the following scenario. During an economic recovery, RGDP grows as 3% as unemployment falls rapidly. Once full employment is reached, growth slows to 2% and unemployment stabilizes. A soft landing. Now assume NGDP grows at 5% throughout this entire period. What happens to inflation?

Inflation would rise from 2% to 3% once we had reach “full employment.” But this is NOT at case of strong growth pushing inflation higher, indeed in my example the rise in inflation was caused by a slowdown in economic growth (given the stable path of NGDP.)

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