Wednesday, March 26, 2008

Initiating and sustaining inflation 

At least two decades ago I tried to co-author a paper with someone (who deserves to retain his innocence for what I'm about to write) over what initiates inflation versus what sustains inflation. The old Friedman statement that "inflation is everywhere and always a monetary phenomenon" seemed to us to be more a statement about what sustains an inflation. If you never print money, you shouldn't get inflation that lasts long at all. Indeed, you'd think you would get no inflation at all (some define inflation purely as an increase in the money supply without reference to price indices of any type.)

So the question was, what causes an increase in the supply of money? Not too long ago reaction functions were all the rage, replaced by Taylor and McCallum rules, but basically making the money supply or a policy interest rate a function of observed economic phenomena. What's in those functions? "Policy choices", you say, and I say "sure, but why did you make those choices?" We argued that the institutions of a country mattered for that; so too do the preferences of the polity. Germany has a greater aversion to inflation than Italy; it chose institutions that expressed that preference. Thus the things that initiated monetary accommodation -- that led to the monetary expansion that sustained the inflation -- could be different things in different places. My co-author and I share an aversion to one-size-fits-all explanations of inflation.

But I never found this a terribly satisfying explanation. Why do Germans hate inflation more than Italians? Sure, the Germans had hyperinflation, but the Hungarians had worse -- are they somehow more foolish than Germans? Made no sense to me. And so when the paper drew rejection letters from several fine journals, we got the message: Bad idea, go back and try again. We went back, came up with different stuff, moved on.

I write all this as prologue to reading John Palmer's explanation of the current macroeconomic situation.
Every time I look at the data, it seems pretty clear to me that if aggregate demand is pushed upward, then in the short run the economy will experience reduced unemployment rates and (often with a lag) higher rates of inflation. During such a period, the unemployment rate drops below the natural unemployment rate (or the NAIRU), and that seems pretty much like what the North American economies were experiencing during the past few years.
And I keep reading that, and I ask: what initiated that increase in aggregate demand? He's suggesting that the inflation is, in the old language of my grad school days, demand-pull. But what was the first thing that pulled demand? War spending? Investment? Housing boom? Or perhaps the first shock came by a slowdown in productivity, which led to a cost-push inflation. Which is it?

Commenting on that post, Mike Moffatt says that "treating the current situation as a demand-side problem is terribly misguided." But even a supply shock is often accommodated by easy money because that's what the system prefers; the economy's closeness to a national election affects that choice. So too does the possible rapid loss of liquidity in the system, which is what I think Arnold Kling means when he says "The central bank matters more as a lender of last resort than as a monetary authority." If the central bank faces a suddenly illiquid financial system, it may accommodate inflation in order to provide liquidity. Some might see that as seat of the pants monetary policy, but it feels vaguely familiar.

John's story, as I read it, seems to assume a constant level of full-employment GDP. I mentioned the productivity slowdown before -- but even there, it's growing more than it did in the 1970s. knzn suggests it's actually better than you think.

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