Inflation basics [Econ for poets]

I recently had a conversation with a smart acquaintance about monetary policy, and we discussed the new Bank of Japan’s governors’ promises to push for higher inflation in the country. I tried to argue that we had good reasons to believe that such an inflationary policy could boost the real economy, while my friend argued against me. But eventually, I realized that the friend and I were doing a bad job articulating what, exactly, drives inflation, and this was a drag on our conversation. I suspect that there are a lot of us who know how to use all the words we see associated with inflation in magazines (“money supply,” “loose monetary policy,” “inflation expectations,” etc. etc.), who may even remember a mathematical formula from Intro Macro (MV = PQ), but who, when we dig a little deeper, have to admit we don’t have a clear grasp on what’s going on. So I thought I could do the blog world a favor by writing a very back-to-basic post (in English words) on what inflation is exactly and how it happens.

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What is inflation? It is a rise in the prices of goods and services. What causes inflation? Most people would say that  inflation is driven by an increase in the amount of currency or money in the economy — the “money supply.” The intuition here is that if an economy produces the exact same amount of goods in year 1 as in year 2, but there is twice as much money in circulation in year 2, then prices will have to double in order to sort of “soak up” the extra money. I think that’s the implicit metaphor most of us have for how it works: The monetary price of real goods is determined by the amount of money in circulation relative to the amount of real goods; and inflation (and deflation) is driven by increases (and decreases) in the money supply. Now, the interesting thing about this is that it is mostly true in practice but not entirely true in theory. To get a much better grasp  on this, we need to go back to very basic theory, to make sure we’re clear on things, and then we need to clarify exactly what we mean by the “money supply.”

Who sets prices? Theory: In a market economy, everybody sets prices. That is, the price of anything in a market economy is the price at which sellers choose to sell their goods, provided that they can find buyers. So any full explanation of inflation has to answer the question: Why, exactly, did sellers choose to raise their prices and why did buyers go along with it? So let’s start with an incredibly simple model: Adam and Barbara are stranded on a desert island and they have their own economy. Adam grows peaches on his peach tree; every day, he harvests a bushel, eats a peach for himself, and sells the rest to Barbara; Barbara then eats a peach, turns the rest into peach juice, drinks some of it, and sells the rest back to Adam; Adam drinks some of the peach juice and uses the rest to water/fertilize the soil of his peach tree. One day, a $10 bill falls from the sky. Adam and Barbara decide to use this for their transactions: First, Barbara gives Adam the $10 bill in exchange for his peaches; then Adam gives Barbara the $10 back for her peach juice.

Now, suppose that two more $10 bill falls from the sky, one into Adam’s hand and another into Barbara’s. What will happen? Will prices triple? Well, that’s up to Adam and Barbara. They might just decide to save their new $10 bills and continue trading one day’s worth of peaches and one day’s worth of juice for $10, every single day — the only thing that would have changed from before would be their “savings.” But it also is possible that prices could increase. Maybe one day Adam gets greedy for dollar bills, and decides to demand $20 from Barbara for his peaches — he knows she has the money, and since he’s her only supplier, she has to consent. At that point, since Barbara now expects she’ll have to pay $20 for future supplies of peaches, she’ll start charging $20 for a day’s worth of peach juice in order to maintain her living standard. So suddenly prices double, just like that. And it’s also possible — this is the really interesting part — that prices could more than triple. Perhaps Adam gets really greedy and starts to charge $40 for his peaches — more than all the currency in the economy — and Barbara responds by charging $40 for her peach juice as well. One way this could work is that, first Barbara buys half a day’s supply of peaches for $20, makes half a day’s supply of peach juice and sells it for $20, and then uses that $20 to buy the next half-day’s supply, etc. Another way they could do this would be to use the magic of credit —  Adam or Barbara hands over $20 for the full amount of peaches/peach juice and also a promise to pay another $20 that night. At the end of the day, after their two transactions, each is $20 in debt to the other, but each earned $20 in cash from that day’s transaction, so they simply swap $20 to settle up.

Now, notably, this simple model is not a good a good one, because it leaves out (1) the reason money is useful and influences our behavior in the first place, namely that is completely fungible and usable across a broad array of transactions that would otherwise be complicated by barter and (2) competition, which is the major thing that stabilizes prices in the first place. But the point of this model has been to get us beyond our implicit metaphor that prices have to “soak up” the supply of money. Adam and Barbara — the market — are in charge of the prices they set, and they do so according to their own purposes. They could randomly double or halve their prices at their whims. And what’s true for Adam and Barbara is also theoretically true for all of us. If every single person in the world were to wake up in the morning and decide to double the prices they pay and charge for absolutely everything (including doubling, e.g. the amount of credit they demand from and extend from others), then this could work without a hitch — every numerical representation of the value of every good would change, and nothing else would.

The above is just a verbal expression of the familiar “Equation of Exchange” that we see in Econ 101, MV = PQ. In this equation, P represents the price level and Q represents the total quantity of real goods sold — multiplied together, PQ thus simply represents the nominal value of all real goods sold in a given time period. So in the second iteration of our fictional desert-island economy above (where Adam and Barbara were each charging $20), PQ = $40 per day. What about the other side of the equation? M represents the supply of money (a total of $20 in that part of the thought experiment). And V is stands for velocity of money, or the number of times any given unit of that money changes hands in a transaction, per time period; in our thought experiment, since $40 worth of goods changed hands a day, and the amount of money was only $30, then the velocity of money was 1.333 transactions per day (($40 of transactions/day) / $30). If you think carefully about this, you can see that MV = PQ is an axiomatic mathematical identity: The total monetary value of all transactions taking place in a given period of time must necessarily be equal to the amount of money there is times the number of times the average unit of money changed hands in a transaction. If prices suddenly double, while everything else stays the same, it must necessarily be the case that money is changing hands twice as fast, doubling V.

So let’s now think about some of the things that happened in our thought experiment, in terms of this identity, PQ = MV. At first, there was $10 in the economy, and $20 worth of purchases, because the $10 bill changed hands twice a day. So PQ = $20 and MV = 2 * $10. It balances! Then $20 fell from the sky. In one scenario, Adam and Barbara didn’t change their prices, so PQ still was equal to $20. Since M was was now equal to $30, V must have fallen to 2/3rd. In other words, since they were still just doing the same transactions, at the same dollar value, even though there were two new $10 bills hanging around, the ‘velocity’ of any given $10 bill was now 1/3rd of what it had previously been — only 2 $10 bills changed hands per day, even though there were 3 of them in the economy. In the scenario after that, both Adam and Barbara raised prices to $40, meaning that PQ was now equal to $80. Because M was equal to $30, V was necessarily 8/3 transactions per day — that is, the average $10 bill changed hands more than twice, because of how Adam and Barbara transacted four times per day.

So going forward, let’s keep in mind this main theoretical takeaway: The only fundamental constraint on prices is the mathematical identity that PQ = MV. So, if the money supply, M, say doubles, that could cause prices to double, but it’s also possible that the extra money could get “soaked up” by a lower velocity of money, i.e., people choosing, for whatever reason, to hold on to any given dollar in their hands for longer before spending it (and it’s also possible that we could see a little bit of each, or that velocity could surprisingly increase, leading to more than double inflation, etc., etc., etc.)

What influences prices? Practice: In theory, the only certainty about the price level is the identity that MV = PQ — the velocity of money could double one day, and halve the next, making prices double and halve in turn. But in practice, things are much different. First, we don’t, in practice, all just wake up in the morning and all collectively decide to double or halve the velocity of money. If I own a shop and I double my prices one day, my competitors probably won’t, and so all my customers will leave me and buy from them. If I suddenly halve my prices, I’ll run out of goods real quick and won’t make a profit. So, because most firms (hopefully!) face real and prospective competitors and don’t like selling things at a loss, the velocity of money, V, doesn’t just randomly, wildly oscillate on its own. This means that if both the quantity of real goods an economy is producing, Q, and the money supply, M, are held relatively constant, then we won’t usually see wild fluctuations in the price level, P.

And second, in practice, changes in the supply of money do not usually get entirely absorbed/cancelled out by changes in the velocity of money. Just think about it: If you suddenly had an extra $100,000 would you hide it all under your mattress? Maybe you would hide some of it (you would probably save much — but these savings would be someone else’s credit, which we’ll get to later), but probably you would increase your spending at least somewhat. And if all of us suddenly got an extra $100,000 we would all probably start to spend a bit more. Since our increased spending would amount to an increase in nominal demand for goods, we would expect prices to rise. So the Econ 101 explanation here is that increases in money lead to an increase in nominal demand, which causes nominal prices to rise. If you prefer narrative to graphical style thinking, think of it this way: if we helicopter-dropped an extra $100,000 into everyone’s bedroom, workers would demand higher pay to work overtime (since they already have such great savings), people would take vacations and bid up the price of spots at restaurants and on airplanes, everyone would be willing to pay more for houses, bidding up prices, etc., etc. But people also would hold onto or save much of that $100,000, meaning that velocity of any given dollar would slow down at first, and so the extra money supply wouldn’t be immediately ploughed into higher prices. So usually the price level should correlate and moves with the money supply, but not immediately in a perfect, linear 1-to-1 relationship.

What is money? In the first few iterations of the desert-island thought experiment, “money” basically means “paper currency.” But in the modern world, most of what we call “money” is actually just debits and credits in bank accounts. For example, if you have accumulated $10,000 in cash at work, and you put that into a checking account, you still have $10,000 in “money” (because you can withdraw at any time) even though your bank is not keeping those $10,000 locked away in a vault. Your bank likely lent most of those $10,000 in cash out to somebody else, and so now there is $19,000+ in “money” resulting from your deposit, even though there was only $10,000 in cash. Indeed, if the person who got that loan from the bank spends her $9,000 to hire somebody a job, and that hiree then saves his $9,000, and the bank then loans out those $9,000 in cash to somebody else, then there is now $28,000 in money. As we can see, in the modern world, “money” is very different from “currency,” and so economists have very categories for measuring the money supply. “M0” refers to actual physical currency in circulation; “MB” (the Monetary Base) refers to currency in circulation, currency stored in bank vaults, and Federal Reserve credits to banks (see below); “M1” refers to currency, bank deposits, and traveler’s checks; “M2” includes savings accounts and money-market accounts as well; “M3” includes all those and a few other savings/investment vehicles. As you can see, M0 through M3 are ordered according to their relative liquidity — M0 is just actual cash, which is completely liquid, and M3 includes things that might take a bit more time for you to withdraw — savings accounts and money-market funds. Money, in the modern world, exists on a spectrum of liquidity. Indeed, it’s arguable that ‘money’ in these traditional categories is too conservatively defined. If you have $10,000 invested in an index ETF, and you can exit the ETF at any moment, you might think of those $10,000 as your money, but the Federal Reserve, at least when it pays attention only to M0-M3, would not.

So how does the Federal Reserve control the money supply? It doesn’t do so by “printing money,” as Fed-skeptics often put it — it’s even more aerie than that! The Fed actually mostly influences the money supply just by entering credits and debits into its and other banks’ digital balance sheets.  Suppose a bank has $100 in deposits from savers like you and me, and it has loaned those $100 to General Electric. At this point, there are $200 ($100 in deposits, and $100 in cash on hand for GE). But now, the Federal Reserve can buy GE’s debt obligation from the bank; the bank thus gets $100 (or whatever the market purchase price of the loan was) in cash credit from the Federal Reserve, which it can then loan out to another company, like Ford. So now there’s $300 of money in the economy ($100 for GE and Ford each and $100 for the banks’ original depositors), with the extra $100 having been created simply by the Fed crediting another bank’s account.

In reality, due to ‘fractional reserve banking,’ each purchase of X that the Federal Reserve makes creates much more than X new money, because banks often lend to other banks, or banks’ loanees deposit some of their loans in other banks, etc. So the Federal Reserve can have a large impact on the money supply simply by purchasing banks’ assets — by giving these banks fresh money, it allows them to lend more money to other people/banks who will lend to other people/banks who will lend again, creating new money at each iteration.

***

I hope this is all the basic background one needs to understand the talk about inflation that we see in the business press. But I want to quickly touch on some implications:

1. This reason all this theory is important is that it explains why Federal Reserve policy is controversial and debatable. If there were a simple, linear relationship between the money supply and the price level, there would be no controversy — we could easily and uncontroversially predict inflation by quantifying the money supply. But Fed policy right now is controversial, for some, because we can’t actually be sure how changes in the money supply will affect inflation over the long run. It’s theoretically conceivable that a central bank could increase the money supply while observing very little inflation, because people largely hide their new money under their mattresses, only to see that 5 years later, everyone suddenly starts spending their mattress-savings, sending prices skyrocketing. The complex psychological factors that influence the velocity of money, including self-fulfilling expectations about inflation (see below), mean that there is always some uncertainty about what the consequences of the Fed’s actions will be. For the record, I’m not very worried about the prospect of very high inflation. The market’s expectations for future inflation are priced into price difference between TIPS (Treasury Inflation Protected Securities) and regular, non-inflation protected Treasuries. And TIPS continue to show low inflation expectations. If I were smarter than the market, I should probably be a billionaire right now. People who are very certain that high inflation is coming should put their money where their mouths are, by putting most of their savings in inflation-protected securities.

2. Expectations for inflation are largely self-fulfilling: If you expect wage rates to rise 10% next year, you might try to lure a new hire with a contract at a 8% premium (relative to current wages), to lock her in at a price that will be a 2% savings relative to what you expect for the future. If you expect prices for your supplies to rise next year, you might raise prices on your merchandise right now, in order to earn enough cash to afford those higher-priced supplies. If you think your competitors are raising their prices right now, then you know you can raise your prices without losing customers. Etc., etc., etc.. The fact that inflation is a sort of self-creating phenomenon, ultimately based on everyone’s best guess about what everyone else thinks about what everyone else thinks about how much prices will rise in the future, is one thing that sometimes makes it hard to control. Most episodes of hyperinflation ultimately originate from governments printing massive amounts of new money — but from there, inflation radically outpaces the printing presses, as everyone keeps raising prices in response to everyone else’s price hikes in a downward spiral. More, one of the most effective ways for the Fed to control inflation is for the Fed chairman to literally make statements — in words — about future inflation. If the Fed says, “we are committed to ensuring that inflation is 3% next year,” the average company will have a good reason to raise prices by 3%.

3. Most mainstream economists believe that moderately higher-than-usual inflation can help boost an economy out of a recession. There are at least four mechanisms through which inflation can benefit a recessionary economy:

          (i) If you own a company and you expect prices to be 8% higher next year, all else equal that fact will make you more inclined to purchase more merchandise now, while prices are still lower. You also might ramp up your production and investment right now, so you’ll be well-position to meet that high nominal demand.  This boost can help an economy get out of the recessionary downward spiral in which low demand and low production begets more low demand and low production.

          (ii)  Most of us think about our salaries in nominal terms. Most of us do not like to take paycuts. However, during a recession, individual workers’ productivity decreases (i.e., if I’m a car salesman, I’m worth more to my company during a time when lots of people want to buy cars). The problem is that if workers’ contribution to companies’ bottom lines decreases, but workers’ salaries stay the same, then firms will hire less and fire more, and/or become less competitive. Inflation allows firms to lower their employees’ real wages, without needing to lower their nominal wages. Economists think this is a good thing — the alternative to lower real wages during a recession is mass unemployment and bankruptcy.

          (iii) Inflating a currency typically devalues it relative to other world currencies. If we make the dollar worth less relative to the Brazilian real, then Brazilians will be able to more easily afford to buy American goods. This should help America’s exporters, which is another thing that can help drag a country out of a recessionary downward spiral. (The flip side of this, of course, is that it will be more expensive for Americans to import things from Brazil — so policymakers have to think carefully through the full industrial implications of a devalued currency).

          (iv) Inflating a currency benefits debtors (at the expense of creditors). If I owe my very wealthy landlord $1 million next year, but prices rise 15% in the interim, then the “real” value of my obligation to my landlord will only be some $850,000. If I as a middle-class consumer am more likely to spend extra money than my ultra-wealthy landlord, then this inflation-driven decrease in my debt/increase in my wealth (and decrease in my landlord’s wealth) will mean greater net demand in the economy. Again, this short-term boost to demand can help jolt an economy out of a downward spiral. You often hear that the problem we’re facing in the U.S. is that, after the financial crisis, everybody tried to “de-leverage” (that is, reduce their debt obligations) at the same time, which led to a “demand shortfall.” (This is often called the “paradox of thrift” — saving more money is good for any individual, but when everybody does it at the same time, it can cause a recession). Inflation can make it easier to reduce our debt obligations, thus weakening the demand shortfall problem that comes with deleveraging.

On the flip side, most mainstream economists believe that in non-recession times, relatively low, stable inflation is good. This is because it’s easier for people to enter into short-term and long-term economic contracts when they can have relatively certain expectation about what things will cost and be worth in the future.

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2 thoughts on “Inflation basics [Econ for poets]

  1. “If every single person in the world were to wake up in the morning and decide to double the prices they pay and charge for absolutely everything (including doubling, e.g. the amount of credit they demand from and extend from others), then this could work without a hitch — every numerical representation of the value of every good would change, and nothing else would.”
    Wouldn’t there be a one-off transfer from existing creditors (and holders of the currency) to existing debtors? Or do you mean that debtors would voluntarily pay back double what they owed?

    I argue that the value of a fiat currency is actually based on the value that can be produced by debtors who owe debts denominated in that currency: http://wp.me/p2IaW7-3c

    • Hi Tim,

      Good catch. You’re absolutely right on both counts. I meant to specify in that thought experiment that outstanding debts and credits would also have to be doubled, in order for everything to go off “without a hitch.” And, you’re right that, without such a doubling of credits and debits, a doubling of all other prices would amount to a transfer from creditors to debtors. Indeed, one of the main arguments advanced in favor of higher inflation in a recession is that it amounts to a transfer from creditors to debtors, exactly as you say.

      All best,
      Matt

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