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malco

What is inflation?

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For a while now I have been thinking about inflation. The measures I am aware of all seem deficient. The "consumer basket of goods" approach can be manipulated, and cannot take account of the appearance of totally new products over time, and the disappearance of others. How do you compare a typewriter with a PC? Or a TGV with a steam train of the 1950s?

 

The "Austrian" view of inflation, based on growth in the money supply, is widely touted by goldbugs, but it also falls down. If the money supply increases by 12%, that does not mean that inflation is 12%, because the scale of economic activity will change over time. As I understand it, an increase in money supply will not be inflationary if the increase in economic activity is the same.

 

But there you have the problem. Economic activity is measured in money. So how can you know if your unit of measurement was subject to inflation or not?

 

You have a circular problem. In order to know the real inflation, you need to know what the increase in real economic activity was; but to find the increase in real economic activity, you need to know the inflation rate!

 

I don't see any way around this. This is why I am very sceptical of historic comparisons of house prices and oil prices. The most pragmatic way around the problem I can think of is to calculate the "average hourly income" and use that as the basis of looking at how real prices change over time. This will not give you the inflation rate though, because it will not distinguish between a price change due to supply/demand shift and a price change due to monetary inflation.

 

Maybe monetary inflation could be identified as a "drift" common to a wide range of purchases - taking us back towards the "consumer basket of goods" approach, but much broader in scope, and not subject to political expediency.

 

And before you ask, no, I don't rate gold as an index to measure inflation. It ain't that simple.

 

Maybe I am being obtuse here. I'd be glad for some mentoring.

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Inflation is widely accepted as being very difficult to measure. Even within countries, the inflation rate can be different.

 

As for money supply, this is big question. A brief summary is below (this has relevance to your point about gold bugs):

 

To take a normal monetarist position, the money supply is exogeneous to the demand for money. I other words, the government and banks produces money at a given level. The amount of times the money is transacted is the velocity of money. The amount of money should match what the real value of a transaction is. If money supply rises too high and/or the velocity increases inflation results. IR increases are one way of reducing the money supply.

 

To take a typical Keynesian position, money supply is endogeneous. Money is created to match the aggregate demand for money. Therefore, the money supply increase becomes a symptom of inflation, rather than the cause. The rate of inflation is therefore controlled by fiscal policy (government spending for instance to increase aggregate demand - Keynesianism works on the premise that crowding out is minimal). Inflation occurs when the economy is running faster than it's capacity. That potential speed can be increased by increasing plant and infrastructure in the longer term.

 

Interest rate rises can also decrease inflation by reducing the demad for money (in the form of credit).

 

Gold bugs tend to be very monetarist, and many seem not to even take into account the velocity of money. For example money being borrowed for housing has a very low velocity, unless it is MEWed.

 

Personally, I take a Keynesian view of inflation (generally). However, a key factor is how money supply is expanded. From my Keynesian POV, I would argue that money that is loaned into existence is endogeneous and thus a symtom of inflation rather than a cause. However, if the money is simply printed without anyone demanding it, then the supply of money in those rare cases is exogeneous and tends to cause hyperinflation.

 

What gold bugs need to look for is the rate of actual money printing rather than broader M3/M4 money supply IMO.

 

To take the example of HPI causing money growth, the issue is excessive demand for housing causing money growth. IMO that should not inflate anything but housing as the money is tied up and has zero velocity. If the money were MEWed, then it would be spent owing to an excessive demand for consumption. If there were a House Price Crash the equity destruction would be deflationary. Aggregate demand would drop, which would be deflationary. The only risk to inflation could be down to a velocity shock, as money circulates more quickly as people liquidate their devaluing property portfolios (or try to do so!) Personally, I think the overall balance would be deflationary. Money can be destroyed as well as created. This analysis ignores international factors which could prove inflationary (such as potentially more expensive Chinese goods if the pound crashed).

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The "Austrian" view of inflation, based on growth in the money supply, is widely touted by goldbugs, but it also falls down. If the money supply increases by 12%, that does not mean that inflation is 12%, because the scale of economic activity will change over time. As I understand it, an increase in money supply will not be inflationary if the increase in economic activity is the same.

 

I agree with a lot of what Humphrey has said although I take a monetarist approach. Money supply is significant although, as Humphrey points out, a lot of monetarists do not seem to account for the velocity of money. This is important because some monetarists try to argue that Japan never suffered deflation on the basis that the BoJ kept M2 growing throughout the recession. The price of a basket of goods didn't fall significantly either but 'discretionary' consumer spending did. Try telling someone who has watched the value of their primary asset fall 60% in nominal terms over a 16 year period and has seen half of their pension wiped out that they are living in an inflationary environment!

 

When discussing money supply, the distinction between money and credit needs to be made. Credit is a promisory note for money - an IOU for so many units of currency. When there is more credit than money (credit expansion) there is always a risk of deflation because not all those IOUs can be exchanged back to the currency on which it lays claim.

 

When you say "an increase in money supply will be inflationary if the increase in economic activity is the same" I presume you are referring to increases in productivity? In my view, increases in productivity can mask inflation. The natural order of things should be constant deflation as a reward for increased productivity. If we imagine a closed-loop system with no new money introduced, as businesses compete and workers become more productive the price of all goods would naturally fall. Workers would then need only to command the same salary over their lifetime to enjoy an increased standard of living. If the money supply is increased in our theoretical system at the same rate as aggregate production, then we have the much vaunted "price stability". The chief problem with inflation is that it rewards those who get their hands on the money first and creates "malinvestment" as this distortion (money with no productive backing) causes misallocation of resources and capital. House building in Ireland being a perfect example.

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The "Austrian" view of inflation, based on growth in the money supply, is widely touted by goldbugs, but it also falls down. If the money supply increases by 12%, that does not mean that inflation is 12%, because the scale of economic activity will change over time. As I understand it, an increase in money supply will not be inflationary if the increase in economic activity is the same.

 

I think you might be confused regarding the Austrian view of inflation. It has been many years since I last read Von Mises, but as I recall it he DEFINES inflation as an increase in the money supply. He does not say that there is in general a strictly proportional increase in prices with an increase in the money supply. As you pointed out, an increase in the money supply doesn't necessarily lead to rising prices (which depends on other factors in addition to the money supply). Ceterus paribus (i.e. - all else being equal), inflation (i.e. - an increase in the money supply) will cause an increase in prices, but I don't recall him ever attempting to apply a formula to this relationship.

Ace

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Jobs created, and wages & salaries paid is a reasonable measure of growth

 

Where Consumption is much bigger than Income, money is being borrowed to comsume.

Some economist believe this to be a good thing. I am not at all sure it is

 

CHINA has pushed for jobs, and increasing its productive capacity, while

 

THE US has pushed for more growth measured by consumption

 

WHO is winning??

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Many thanks for your replies, sorry for the rather tardy response.

 

Sir Humphrey, you provide an admirable summary. Just to make sure I've got it sort-of right:

 

The monetarist defines inflation as an increase in the money supply in excess of what can be justified by increases in productivity; too much money will usually lead to inflation be it by bidding up or asset bubbles.

 

The Keynsian sees inflation being caused by the government spending too much in the economy, straining resources and leading to the bidding up of goods and services.

 

Is there really that much difference? In both cases the economy is being disturbed because it is being "overfed" money (or perhaps I could say "over-FED"?) and this leads to shortages, be it shortages of shares, commodities, cars, houses or what have you. So prices go up. The route by which the money goes into the economy is different and I expect also the sectors affected are different. With a Keynsian expansion the booms would probably be in defence, social projects and health care, whilst monetary expansion would tend to show up more in housing booms, tat like vintage cars and objects d'art, equity bubbles and speculation generally. Both end in a hangover.

 

Still quite tough to define inflation in a way that is meaningful to the man in the street. When I see charts showing oil prices corrected for some measure of inflation going back to WW2, it makes me very sceptical that this means anything. What measure of inflation was used? CPI?

 

I personally find the most useful is average man hours (to compare specific item costs across time). Today the average earning rate is about £12/hr before tax. So to buy a fairly basic bicycle requires about 15 hours' labour. During the Edwardian era to buy a typical roadster took about ten weeks' labour to earn. So that is a pretty clear cut case of genuine improved affordability, even though the Edwardian bike cost 20 quid in 1910 whilst the nominal amount today is £200 at least. Goldbugs might note that the 1910 bike cost 5oz whilst the bike today only about 2/3rds oz. That reflects the real improvements in productivity through mass production, which was as yet only a gleam in the eye of Henry Ford back in 1910. This seems to me a more useful way of comparing prices in time. I'm not sure that there is any meaningful all-encompassing inflation rate - as Dr Bubb points out on another thread, you have to be specific about what you are measuring.

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Sir Humphrey, you provide an admirable summary. Just to make sure I've got it sort-of right:

 

The monetarist defines inflation as an increase in the money supply in excess of what can be justified by increases in productivity; too much money will usually lead to inflation be it by bidding up or asset bubbles.

 

The Keynsian sees inflation being caused by the government spending too much in the economy, straining resources and leading to the bidding up of goods and services.

 

In conceptual terms, the difference is that monetarism is a more reductive theory than Keynesianism. IMO, that makes it more pseudo-scientific. As someone with some science background, threating Economics as a science is not really tenable owing to it's poor empirical basis. Treating economic models as Instrumentalist tools has severe limitations owing to externalities. Therefore, taking a more holistic approach is more appropriate IMO since the mechanisms that many economists are fond of do not exist in a literal sense.

 

The key difference between an Austrian (supply-side) economist and a Keynesian is the effectiveness of different stimuli. An Austrian economist believes in highly efficient markets, and the only way to control the market is to decrease/increase supply of goods to meet demand. Fiscal stimulus such as public spending does not work owing to crowding out, (so the Austrian believes).

 

A Keynesian believes the reverse in general. A Keynesian increases taxes and/or cuts spending during periods of growth and cuts taxes and/or increases govt spending in a downturn. This countercyclical spending is used to smooth the business cycle to avoid recession (as for why see comments about hysteresis below).

 

A Monetarist reduces the whole fiscal/monetary policy debate to controlling money supply.

 

So to use the example of House Price Inflation. A monetarist would restrict the supply of money. The trouble with this is (A) determining the demand the money (:( there is a poor correlation between money supply and inflation after 1980 and © if the economy is in recession a monetarist tedns to favour fighting inflation over stimulating growth which IMO is crazy - being reductionists they tend not to think of people, just mechanisms.

 

An Austrian would do that and let builders build lots of houses, including in National Parks and areas of natural beauty.

 

A Keynesian would not try to restrict money supply (as it is endogenous to the demand for money). A Keynesian could justify raising IRs to cut of demand for money, but would see it as a blunt instrument that would also badly affect other parts of the economy. For instance, a Keynesian tends to beleive that economic damage caused by recession can be permanent (hysteresis). So a Keynesian would try to maintain manufacturing infrastructure for instance. A Keynesian would prefer to target HPI by restricting the number of properties owned, raising land/council taxes and increasing council housing to reduce the demand for housing.

 

Part of what determines what is effective is the structure of the economy. A country with lots of manufacturing has to be Keynesian and to avoid deep recession to prevent the build up of "rust belt". A service based economy ought to be able to take a recession with less permanent damage as it is easier to open a restaurant than re-open a factory. IMO, an economy ought to have a balance between the two. IMO, part of Thatcherism's contempt for manufacturing (which continues under New Labour) was to restructure the economy to make it more amenable for Supply-Side economics.

 

The question is whether this will serve Britain better than manufacturing (I doubt it). Although manufacturing was in decline, it is still healthier in mainland Europe which suggests that government intervention (or lack of intervention) makes matters worse. Asset strippers also find it easier to operate in the UK. IMO, Britain is far more vulnerable to imported inflation than other European countries owing to the high trade deficit resulting from the dismantling of often viable manufacturing capacity.

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