Friday, April 20, 2007

Causes of Inflation

KNZN reports on debates he's had over the causes of inflation. Apparently he is being chided for suggesting that inflation could be produced by tax cuts. Inflation as we all know is everywhere and always a monetary phenomenon.

Well OK, but does that mean that inflation can only be caused by increases in the money supply? Well, of course not. Money is in the equation somewhere but its not the only factor.

Suppose, for example, that I managed to organize the greatest trade union known to man. In fact, all workers in the United States are members of my union and they all obey my commands.

Now, I decide that I am going to decrease labor supplied to the US economy to fight the evil capitalists. The workweek will be reduced 1% per month from now until I decide otherwise.

Now the Fed believing that inflation can only be caused by increasing the money supply decided to keep the monetary base constant. What is going to happen?

Well, as my minions slowly retreat from the labor market output will decrease. Given that MV = PY and M and V are constant, decreases in supply must be eventually matched by increases in price.

In a similar way I believe that KNZN is arguing that tax cuts can actually increase V by causing the supply of bonds to grow. Without a corresponding increase in the growth rate of Y or response by the monetary authority to decrease the growth of M, P must also grow. If an increase in the growth rate of prices is not inflation, what is?

17 comments:

Gabriel Mihalache said...

With the risk of repeating an undergraduate exposition of little interest...

Differentiating MV=PY in regards with time yields us:

M dV/dt + V dM/dt= Y dP/dt + P dY/dt

Dividing by the original equality (the LHS by the LHS, the RHS by the RHS):

dM/dt/M + dV/dt/V = dP/dt/P + dY/dt/Y

noting x = dX/dt/X and rearanging, we get:

p = m + v - y

Caeteris paribus, an increase in prices (INFLATION) can be caused by either an increase in the money supply, an increase in the velocity or a decrease in output.

The questions is... in which way can tax cuts affect the price level? The Quantity Theory only allows for 3 channels.

Karl Smith said...

^

This is why I say that KNZN is simply saying that tax cuts increase velocity.

YouNotSneaky! said...

I think the point of the "always and everywhere" statement is that a *sustained* change in the price level can only be due to monetary factors once one accounts for trend real gdp growth. Tax cuts, government spending, oil shocks can cause one time changes in the price level (of course as the economy moves from one equilibrium to another you will see inflation/deflation) but eventually the effect of this shock will peter out and price level will return to being constant.

If you want sustained inflation you have to keep shocking the economy. Keep cutting'em taxes. Keep raising that price of oil. Keep increasing that government spending. But there are natural or at least practical limits to all these so they cannot account for sustained inflation. Only monetary growth can. By the QT as Gabriel points out, it takes a growth variable to affect a growth variable here.

Your super union would have to keep decreasing their labor supply by a constant amount every period to sustain the deflation, until they're all working an epsilon amount of time.

knzn said...

YouNotSneaky! has a point. But a tax cut usually is not a one-shot deal; most tax cuts seem to be intended as permanent, and they are often large enough to result (theoretically) in a permanent increase in the growth rate of government debt and thus a continual increase in the velocity of money. (In a comment to one of my posts, Gabriel suggests that bonds are sufficiently liquid to be considered money, in which case it’s not the velocity of money but the quantity of money that would grow continually.)

You can argue that this process can’t go on forever, because the government has an intertemporal budget constraint. But there are several counterarguments. First, if the growth rate exceeds the interest rate, the government may not have a budget constraint. Second, assuming it does have a constraint, the time frame over which it applies is very long, and, say, 10 years worth of continual price increases is, for practical purposes, inflation, even if it’s ultimately limited in time. Third, politically, it’s hard to see why one should ever be confident that the problem of exploding government debt would ultimately be solved by fiscal policy rather than monetary policy. (This is a concern in my original argument, which had to do with how the Fed would or should respond to a tax cut: the Fed has to respond in the short run to maintain its credibility.) Finally, if fiscal policy is able to produce rising prices, then even if the government’s budget constraint applies in nominal terms, it may not apply in real terms: the nominal growth rate of the debt could rise permanently, but the nominal growth rate of GDP would also rise, and the debt-to-GDP ratio would not necessarily rise.

YouNotSneaky! said...

KNZN is pretty much right about the fact that the growth rate of the deficit vs. the interest rate matters, and that the transition to new equilibrium can take a long time and can for all practical purposes be considered "inflation" rather than "price level change".
My aim was more to point out the context in which the original quote was meant, not lay it down as dogma.

Still, it's hard to see how moderately high inflation and above can be anything but a monetary phenomenon. The other things may matter for some increases at low levels of inflation.

Also, I suspect that while the V may be volatile it's average growth rate is probably low, though not being a monetary economist I don't really know.

dWj said...

There's a lot of nuance that hides behind "ceteris paribus", and often perspectives depend on which cetera we're keeping pariba.

There are people who like to talk about sustained deficits having inflationary pressure. You can do some math and find ways of making yourself believe them, but they generally feel epistemologically suspect to me. What does make sense is that sustained deficits would raise interest rates. If the fed is controlling interest rates, though, in order to keep interest rates where they would be in fiscal balance, they have to keep monetary policy easier than it would be at the same interest rate in fiscal balance.

When I read, "the government ran big deficits, forcing the fed to raise rates to stave off inflation," I think, "no, the fed simply followed the natural rate of interest up so as not to produce inflation". The former makes sense if your concept of the natural thing to do is for the fed to artificially suppress interest rates to the level they were at before. The latter -- well, to be honest, I'm not sure it's as well-defined. But I'm happier with it than with the former, though I'm still wrestling a bit with both.

knzn said...

See my latest post on this topic.

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