Cartoons and the mythical Deflation Monster

Mahalanobis points us to some ECB cartoons about inflation:

The European Central Bank, in cooperation with the national central banks of the euro area, has produced an information kit entitled "Price stability: why is it important for you?" for young teenagers and teachers in all the official languages of the European Union.
This tool consists of an eight-minute animated film [Quicktime, Real Video, Windows Media] leaflets for pupils (pdf) and a teachers' booklet (pdf). The film features two secondary school pupils, Anna and Alex, finding out about price stability. The leaflets provide an easy-to-understand overview of the topic, whereas the booklet covers it in greater detail.

What the cartoon totally misses, of course, is that the "inflation monster" is not merely "stabilized" by the central banks, but caused by them. It is "stabilized" by how fast they choose to erode the value of our money. If the supply of money remained constant, we would instead experience *deflation*, as the price of goods decreased due to technological innovation. The decreasing nominal price of goods would actually reflect their changing cost, instead of being hidden by the decrease in the value of money. (No wonder there is a set of people who think that most resources are becoming scarcer!)

The video says: "If all prices are steadily declining, you'll delay buying something, expecting it to cost less a week later, and even less a month later. For the same reason a company might decide to postpone its investments, and the economy might suffer." Of course, as anyone who has bought a computer or an iPod knows, people already delay buying things because they are going to cost less in a few months. It's good to take into account the steady march of innovation - it helps us make more accurate spending decisions. There is a big difference between deflation due to a contracting money supply, and deflation due to things actually getting cheaper. Yet central banks seem to only talk about the rare occurences of the former, justifying the steady hum of their printing presses, rather than the omnipresent latter.

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Patri, ... If the supply of

Patri,

... If the supply of money remained constant, we would instead experience deflation, as the price of goods decreased due to technological innovation. The decreasing nominal price of goods would actually reflect their changing cost, instead of being hidden by the decrease in the value of money. (No wonder there is a set of people who think that most resources are becoming scarcer!)

The number of factors that determine the purchasing power of money is effectively unlimited. In the end, the purchasing power of money is determined by the subjective decisions of all money using individuals whether to buy or not buy a marginal consumer good with a marginal dollar.

Besides the supply of money and the supply of goods, factors include such things as :

1. Money using population size.
2. Credit cards and other sources of credit, among many possibilities that economize on the use of money.
3. Paycheck period. (weekly, monthly, yearly)
4. Budgeting of paychecks.
5. etc.

In any case, any attempt to stabilize prices by the manipulation of the money supply is not only futile, but extremely counterproductive. Of course, stabilization is only a smoke screen. The motivation for inflating the money supply is the same as for any counterfeiter.

Regards, Don

Patri, ...The video says:

Patri,

...The video says: “If all prices are steadily declining, you’ll delay buying something, expecting it to cost less a week later, and even less a month later. For the same reason a company might decide to postpone its investments, and the economy might suffer.” Of course, as anyone who has bought a computer or an iPod knows, people already delay buying things because they are going to cost less in a few months.

A completely bogus claim in the video, in any practical, large scale sense.

For any individual to logically delay the purchase of a consumption good, he must expect the price to fall at a faster rate than his rate of time preference for present consumption over future consumption. This is a tough test, and only applicable for goods of weak subjective value. In any case, the lower prices in the future, if caused by monetary factors, would only be nominal prices, not real, adjusted prices.

Companies are in business to earn high rates of return on investment. This cannot be accomplished by sitting back and waiting. Falling prices will tend to result in lower nominal profits, but not in real, adjusted terms.

Regards, Don

Anime-style infaltion

Anime-style infaltion propaganda! What will they think of next? :lol:

Don, thanks for the

Don, thanks for the explanation. It makes sense. ... but I don't think it's correct.

It would be if the Fed dropped money from the proverbially famous helicopter. Prices in the area of the helicopter drop would be affected first - or rather, prices of the things that the people in that area wanted to buy (or sell).

But in a credit-based monetary system, the money supply is expanded when banks decide to create more credit and offer it to the public at large. That necessarily lowers the interest rate until the supply of and demand for credit are matched. The people who get the newly-created money are the people who borrow it at the new lower rate, and the things whose prices get distorted are the things those people spend money on.

Well, everyone is a potential borrower. Everyone can take advantage of reduced interest rates to open or increase a line of credit. Businesses, families, students, housewives, teachers, plumbers, you name it... pretty much everyone except the homeless. Which means the prices that get distorted are the prices of, well, everything. Which is no distortion at all.

What's really being distorted is the price of intertemporal exchange - the nominal interest rate. But a distortion in the price of present goods vs. future goods doesn't imply a distortion in the price of present shoes vs. present groceries. And the intertemporal distortions will be minimized if the difference between nominal rates and real rates is minimized, i.e. the expectation of price-level inflation or deflation is small and stable.

In any case, the lower

In any case, the lower prices in the future, if caused by monetary factors, would only be nominal prices, not real, adjusted prices. [...] Falling prices will tend to result in lower nominal profits, but not in real, adjusted terms.

Don is correct. If nominal prices rise by 50% tomorrow and fall by 90% the next day, it won't change the number of apples it takes to buy a case of oranges. However, both inflation and deflation create winners and losers. Deflation benefits holders of money, debt, and payment contracts while injuring issuers of debt and payment contracts.

Patri's distinction between deflation due to technology and deflation due to a contracting money supply isn't relevant. Technology makes things cheaper in terms of inputs, but that has no bearing on the general price level. If the price of inputs were kept constant, there would be consumer-level deflation; if the price of products were kept constant, there would be producer-level inflation.

A constant money supply would cause price levels to fall as the demand for money increased and would cause them to rise as demand for money fell. Population increase will cause the total demand for money to increase and thus will lead to a decline in the general price level, i.e. deflation. But is that desirable? Why should borrowers benefit at the expense of lenders simply because the money supply is being held constant?

Suppose borrowers and lenders could choose whether the money supply would be price-level inflationary, price-level deflationary, or price-level stable. They actually wouldn't care one way or another, as long as the rate of inflation or deflation were predictable and stable; they would then be able to factor it into the interest rates they agreed upon. Borrowers would prefer to see unexpected inflation, lenders would prefer to see unexpected deflation; by negotiation, they would agree to an environment in which neither unexpected inflation nor unexpected deflation were likely - in other words, stable rates of price level changes.

An argument can be made that rates of change can be kept most stable when they are small, i.e. no more than mildly inflationary or mildly deflationary. A constant money supply, being price-level deflationary, may do a worse job of meeting the needs of lenders and borrowers simply because it would be too deflationary to allow for stable expectations of future price levels.

Eddie, I believe you are

Eddie,

I believe you are mistaken.

If the exchange ratio of Apples to Money is A/M, then if I increase the amount of A I lower the ratio (i.e. lower the price). Money stays the same but prices fall due to increased production.

If one increases M relative to A, you raise the price of Apples with no increase in production or wealth.

The reverse is true in both cases as well.

That is Patri's distinction in a nutshell and it is not irrelevant. The latter change is undesirable while the former is desired- because if you keep M constant then prices reflect scarcity, demand, production, and supply- in other words, by keeping the money supply stable you increase the quality & precision of the information signal that prices give other producers and consumers, helping coordinate activity in the economy.

The demand for money is (among other things, as Don will likely explain) tied to and dependent upon the demand for the ability to trade, and this demand is not constant. Thus a rising population tells us only that the demand for things is probably going to increase, but doesn't tell us by how much, and it carries its own confounding factor, which is that every consumer is generally also a producer (unless you're, say, Paris Hilton or something, in which case you've simply separated consumption and production in time), so if the production of the population that is increasing is on par with or greater than their demand for consumption goods, the net effect on prices will be to reduce them (supply of commodities will outstrip demand for money to exchange for them).

Asking for a stability and no unexpected price changes is to ask for a static and stagnant economy (or at best the "evenly rotating economy"). This economy doesn't exist because it is incompatible with objective reality, which is dynamic and constantly changing. To try and enforce such a monetary regime is to destroy the signal that prices give in favor of an essentially random noise where exchange ratios (prices) are arbitary.

Money is not there to meet the needs of borrowers and lenders, but to meet the needs of buyers and sellers (money being the most salable commodity, allowing translation of exchange values by being the common denominator). That a constant money supply would put differential pressure on borrowers and lenders over time is a feature, not a bug.

Brian, Very good. I only

Brian,

Very good. I only have an extension.

It is not a stable money supply per se that is desireable, but a restraint from artificial manipulation of the money supply in response to prices or just in order to increase the purchasing power of the manipulator.

If, under a gold standard, miners add a few percent to the gold supply in a given year, it is folly to try to compensate by removing gold somewhere else.

Money is non-neutral, meaning that changes in its supply affect all goods and all people to different extents. The increase or decrease in its supply can only work its effect into the economy over time and starting in a specific place, and in the process corrupting relative prices. These corruptions are largely permanent and do not disappear after the effects of a monetary supply change have died out. There is no way to judge whether the new configuration of prices is better or worse than what it would have been without the monetary supply change, but the change itself has produced frictional losses due to the unnecessary transactions that result and these losses can never be regained.

Regards, Don

Brian, Continuing the apples

Brian,

Continuing the apples model, with the understanding that "apples" represents the total quantity of goods and services produced by the economy... You're right that case one (apples increase and money stays the same) is better than case two (apples stay the same and money decreases), and you're right that both represent price-level deflation. But you draw the wrong conclusion.

What's of benefit in case one is that the number of apples has increased. This would be true whether the money supply remained constant (lowing the price of apples), increased in accordance with apple production (keeping prices stable), or increased faster than production (causing prices to rise).

Keeping the money supply constant so that we can all say "hey, look, the price of apples got cheaper, our economy must be growing, whee!" is of no value. It does nothing to help producers and consumers make decisions about how to allocate their resources. It only affects the general price level, i.e. it affects the prices of all goods and services identically.

The decisions that are affected by changes in the general price level, i.e. by changes in the money supply, are strictly those of intertemporal allocation - borrowing, lending, present consumption versus savings, and capital formation. If I think prices are going up (or down), I'll increase (or decrease) my nominal intertemporal discount rate accordingly to match my real discount rate. My intertemporal decisions and those of the people I exchange with will be more efficient if all of us can accurately estimate how much we should offset our real discount rates by to arrive at our nominal rates. Which means we want price level changes to be stable. Which means they should also be small. Which means the money supply should grow roughly in accordance with the economy (with variations to account for people's changing preferences for holding money) rather than staying constant.

If you were negotiating a long-term contract, would you prefer its monetary terms to be denominated in a currency that you expected would maintain a stable exchange rate with respect to a broad basket of goods and services, or a currency which would be fixed in quantity but whose future exchange rate with respect to goods and services you were unsure of?

Don, I agree with your

Don, I agree with your extension. Using monetary policy to (for example) inflate currency, depriving current holders of purchasing power and transferring it to the currency issuer is reprehensible.

In my opinion, a competitive free-market monetary system would have currency issuers competing for the wide-spread use of their currency. Currency users would prefer money that was neither inflationary nor deflationary in the long term. If we could all dump our Greenbacks when we thought that the Fed was going to crank up the printing presses and make them worthless, then dump them we would... and then the Fed would stop inflating in an effort to win us back.

Could you explain your non-neutrality argument a little more? I've seen it mentioned elsewhere, but I'm not persuaded, or perhaps I don't understand it. Clearly the Fed could print money and the Federal Government (ptui!) would be the unworthy beneficiary, but you're suggesting that it would also distort relative prices between different goods and services? I don't see how that follows.

Eddie, Could you explain

Eddie,

Could you explain your non-neutrality argument a little more? I’ve seen it mentioned elsewhere, but I’m not persuaded, or perhaps I don’t understand it. Clearly the Fed could print money and the Federal Government (ptui!) would be the unworthy beneficiary, but you’re suggesting that it would also distort relative prices between different goods and services? I don’t see how that follows.

If you are the first one to receive a newly printed dollar, nothing happens until you make a spending decision that differs as a result. If you now buy a widget that was considered too expensive before your marginal utility of money was diminished by the addition of the new dollar, you have effectively started to bid up the market price of widgets. Now the new dollar is in the hands of the widget seller, and he may bid up the price of some other good that is marginal to him. So on and so forth. The market prices of different goods rise on a step by step basis as the new dollar disperses throughout the economy. However, anyone that is far along the chain may well see some of the prices of goods that they buy rise before they see any new dollars. This may mean that matginal goods that they had originally purchased are no longer purchased because other goods' prices have risen. This means that this marginal good may see its market price fall due to lower demand. While overall prices are likely to rise, some goods will see their prices fall. No two goods nor no two persons will have the same sensitivity to a change in the money supply.

Thus relative prices are corrupted as there is no possibility whatever of uniformly and neutrally increasing the money supply. You could re-define the monetary unit so that 1 dollar = 2 rallods, but this is not a real economic effect.

Regards, Don

Beware of the Inflation

Beware of the Inflation Monster
Freaking cool: The ECB has a neat little cartoon film aimed at students to explain price stability and inflation. I totally dig it. Go and watch it, especially if you’re one of those who always doze away in the Economics 101 class, because you p...

Eddie, Some parts of what

Eddie,

Some parts of what you say I agree with, and some parts I don't. Rather than go into detail, I will prove that relative prices must be affected.

If you, or anyone else, receives new dollars, either in the first wave or in any subsequent wave, then prices will be effected only if and when you make a resulting changed purchasing decision. This is true for both new cash or new credit.

If you make a new purchase of a widget because of the reduction in your marginal utility of money, then the market price of widgets will tend to rise because of increased demand.

If alternatively, you make a purchase of a premium widget instead of a standard widget, then the market price of a premium widget will tend to increase while that of the standard widget will tend to decrease, resulting in a change in relative prices. Note that any two goods can be involved in the substitution, not just related goods.

The major economic distortion is a change in the relative pricing of a final consumer good and that of its production factors. The change in profitability has the potential to severely disrupt production and destroy accumulated capital.

Regards, Don

eddie, Why should borrowers

eddie,

Why should borrowers benefit at the expense of lenders simply because the money supply is being held constant?

Better question: Why should anyone control the "money supply" any more than the coffee or automobile supply?

Don, The motivation for

Don,

The motivation for inflating the money supply is the same as for any counterfeiter.

Would it be okay to make and pass conterfeit money if you only used it to pay taxes?

John: Why should anyone

John:

Why should anyone control the “money supply” any more than the coffee or automobile supply?

I've never suggested anyone should.

But please note the context of this discussion. Patri was criticizing central bank decisions to control the money supply to keep prices stable, and suggested a constant money supply and its accompanying price-level deflation would be more desirable. My points had to do with the merits of price stability versus deflation, not whether the money supply should be controlled by someone. A constant money supply implies no less control than does one that expands with the economy to maintain constant price levels.

Moreso, actually; I posit that in a truly free banking system, currency users would prefer currencies that resulted in stable prices. Anyone desiring a "constant money supply" would find few customers for their currency unless they used force to shut down their price-stable competitors... but that wouldn't be a free market, then, would it?

And for the record, I'm firmly in support of free-market non-centralized non-coercive monetary systems, your clever quip about cars and cappucino notwithstanding. :)

air conditioner makes a good

air conditioner makes a good point here. Your rejection of monetrism failed to consider the air conditioner effect, in which great buys can be had for air conditioners if one only goes to the air conditioner blog. I say money supply, schmoney schupply- give me tidbits about air-con updated daily on a journal-style webpage.