What is inflation?
Posted July 5, 2008on:
Note: Other posts in this discussion are available under the tag “inflation debate“.
Thank you for all the insightful and intelligent comments (and posts on other blog) on the Re-thinking monetary policy post. Now that you guys have put down the important issues that we have to look at with monetary policy all I need to do is discuss them with my own opinions
However, even with all your help we can’t just jump straight in to saying whether policy should change or stay the same. First we have to define what the hell we are talking about! This involves starting with the question, what is inflation? Once we know what inflation is, we can figure out what the costs of inflation are. From there we can work out what trade-off exists when dealing with inflation, and then we can sort out whether current monetary policy is dealing with this trade-off appropriately.
There is a simple answer to what is inflation, but it isn’t particularly useful. The simple definition is that inflation is “the rate of change” in the general price level (*). To really understand what inflation is though, we have to understand what causes growth in the general level of prices.
Here I will go over some points that build off each other (the fundamental points are in italics, the bold bits are just titles ). If you disagree with a specific point, raise your criticisms and we will discuss it and try to figure out where to go from there. Hopefully painting it out this way will make the final description transparent.
Point 1: Price changes and inflation
As Peter said here (*) it is important not to confuse inflation with relative price movements. The whole purpose of prices is to indicate the value of goods relative to other goods. When these relative prices change it is efficient to let them change, instead of using artificial tools to try and stop them changing.
In this sense the increase in the price of food and oil is not “inflation” – it is a relative price movement that is sadly making people poorer at the moment (although in the case of food it could well be making us wealthier).
The inflation we are concerned about is when the price of all goods consistently (ht Paul Walker) increase for no “real” (as in a change in underlying economic circumstances) reason.
Point 2: Inflation in this sense stems from
Most simply this type of inflation stems directly from the growth in “money” in the economy above growth in the quantity of real products – where the quantity of “money” in a given time period simply equals the money stock times a “velocity” measure, that tells us how quickly this money stock moves around the economy. (Quantity theory).
If there is a greater growth in the amount of “money” (in this sense) then there is real products then the nominal price level of goods will be bid up (more dollars chasing fewer products).
The fundamental problem with this definition is the circularity implicit in velocity. How quickly the money stock is moved around the economy depends partially on the current level of prices while the current level of prices will depend on the velocity with which money moves around the economy. (For people that know about the quantity theory, I’m saying that velocity is not a constant – an increasingly mainstream view among economists).
As a result, peoples expectations of the price level will play a role in determining inflation, even if the money stock was fixed!
Point 3: Drivers of “money” growth
Like all economics the study of monetary aggregates enjoys a relationship with supply and demand. The supply relationship enjoyed alot of attention for a long time, with the idea of targeting a fixed quantity of money supply growth providing a popular pastime for many central banks.
However, this view of money supply is a bit misleading when we view “money” in the way we are here. The money supply in this case is truly the money stock – it tells us the quantity that is currently derived, it doesn’t tell us anything about the supply and demand relationship that is causing it.
Currently the Reserve Bank sets an “interest rate” by choosing their official cash rate. As an interest rate defines the price of money (as a higher interest rate increases the opportunity cost of holding money), by setting the interest rate the Bank can move up and down the “money demand” curve. Money demand is the constraint that the Bank pins itself to when setting interest rates – not the stock of money. As a result, as long as the quantity of money demanded falls as the interest rate rises, and as long as the Bank has an ability to decrease and increase interest rates, then inflation can be controlled by the Bank’s choice of interest rates. (Note: Printing money would only work if there is sufficient demand – which requires lower interest rates!)
Source: University of Rhode Island (*)
Now it is all well and good to say that the money stock is rising in NZ, as it is. However, it is the relationship with money demand that is the essential component behind this money growth. If people are not willing to borrow the money at that given interest rate then all this “credit creation” does not matter.
Point 4: Drivers of money demand growth
There are a large number of factors that drive money demand growth, many of which are mentioned at about.com (*). We’ve already mentioned interest rates (as the effective “price”), but there are some other factors that “shift” the money demand curve (we are focusing on “real” money demand – as a result, inflation is not listed below. However, actual inflation will increase “nominal” money demand). Factors that will increase money demand are:
- Greater demand for goods and services,
- Lower levels of liquidity/precautionary motives,
- Higher inflation expectations,
- An increase in foreign demand for domestic goods/assets,
- An increase in foreign demand for domestic currency holdings
Now in fact, we are only interested in factors that increase money growth that in turn is used to bid up the price of goods and services (All the way back from point 2). If the Reserve Bank works to keep the interest rate constant, factors 2 and 5 do not do this, as neither of these factors are used for goods and services.
Factor 1 is inflationary if this increase in consumer spending is in excess of what is justifiable given productive growth in the economy. Here the increased demand for money will gradually bid prices up.
Factor 3 is also inflationary. If people increase their demand for money given that they expect prices to increase then prices in the economy will be bid up, causing the inflation that was feared. The clearest (and most consistent) example of this is a wage-price spiral whereby inflation expectations lead to larger wage demands, which increase firm costs, which lead to larger price increases.
Factor 4 would not be inflationary if the increase in exports was met with a corresponding increase in imports. However, if the increase in imports is sufficiently small, then the additional income stemming from higher export values will lead to an increase in inflationary pressures similar to factor 1.
Now in terms of thinking about inflation, factor 1 and 4 are not sustainable – demand is unlikely to remain above economic fundamentals extended periods of time (unless we have an asset bubble which drives up households perceived wealth levels, eg housing). As a result, the fundamental issue at hand is factor 3 (which can be driven by factors 1 and 4). Keeping inflation expectations down will keep inflation down!
As a result, the way I see it, inflation stems directly from the bidding up of prices in the economy which in turn leads to greater money demand. I feel that this overall way of viewing inflation is consistent with both monetarist and Keynesian explanations for what drives inflation – however, the assumptions made within the general framework are different.
However, I am more than willing to accept that I could well be wrong in large sections of the above post – which is why I would appreciate another set of intelligent comments on the “what is inflation” issue. After all, once we have sorted out what inflation is we will have a solid base with which to discuss New Zealand’s monetary policy framework.
When critiquing what I have written I would appreciate it if you attack my points in order (starting with the earliest ones you wish to criticise) and clearly indicate which point you are discussing at all times. Also, if you want to talk about the current monetary policy framework and not discuss this actual post you should head over to the previous post on that issue, which is found here (*).
Thanks in advance