Inflation question

I don't know much about macro, but I have been confused by Bernanke saying that we have high inflation because of high energy prices, and so the fed needs to tighten.

There is a difference between "inflation" - meaning a decrease in purchasing power of the dollar due to printing more dollars, and a "price shock", where prices are going up because things are actually more expensive". In the first place, only nominal prices have increased, but in the second case, real prices have as well.

I can understand why a central bank would want to make inflation happen slowly, so that the conversion from nominal to real interest rates is obvious and consistent, and people are neither afraid to borrow (because of potential deflation) or afraid to lend (because of potential inflation). In other words, if you are going to steal the value of our money, you should do it slowly and consistently, if you want the economy to remain strong.

But how do genuine price shocks have anything to do with this?

Since a decrease in the value of the dollar should cause nominal prices to rise uniformly, "inflation in only one sector" seems like an oxymoron. Shouldn't our inflation index, rather than being calculated on a bundle of goods like the CPI, be calculated based on factor analysis to determine how much of the rise in the price of the goods is due to a single common cause?

Economists out there are welcome to test this, by devising such a measure, and seeing how it correlates to changes in the money supply, and at what lags...

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I suspect he is shifting

I suspect he is shifting blame.

Energy prices have proven themselves to have only marginal impact upon real prices in the economy since energy from oil constituted a very small part of any given product. For most products labor consumed the vast majority of the production costs; and wages are not tied to the price of gasoline.

That said, the money supply has been very lax for a long time, M3 has been growing at something akin to 9% a year (clearly inflationary). In reality, he feels that he needs to raise rates to get this 9% under control, he just needs political cover that people and politicians will understand: Oil Prices :beatnik:

Dude, maybe it's not my

Dude, maybe it's not my place to ask but since you have direct access to two of the greatest minds in economics ever, why ask us?

Also, this looks like a question Greg Mankiw would answer (he often answers to emailed questions on his blog).

Not all inflation is caused by "printing money" in order to steal from the private sector. Have you been hanging with Austrians?! The optimum rate of inflation is the rate at which potential output grows, i.e. new money needed for transationary purposes. Ypotential = M * v for the long run steady-state equilibrium.

As for energy shocks, I think it's easier than that. Most if not all goods and services are reliant on some form of oil-powered transport or processing. If oil prices go up, many prices go up to reflect the new production costs. A generalised increase in prices = CPI = inflation. Inflation (as defined re: CPI) is not incompatible with a reduction in real purchasing power, me thinks.

Patri, You are correct. The


You are correct. The increase in oil prices are for the most part derived from alterations in the supply of (and the uncertainties in the future supply of) and/or the demand for oil. These "high" prices do not an inflation make. Inflation was, is, and always will be a monetary phenomenon. Inflation is the alteration of the supply of and/or the demand for money, generally only by governments, such that the perceived purchasing power has declined. Inflation cannot be measured (by prices...IOW, the CPI doesn't and indeed can't measure inflation no matter what kind of price indexing algorithm or formula you construct), it can only be deduced or inferred by the actions of the economic actors in the market.

No, Patri, a decline in the "value of a dollar" does not mean that prices rise uniformly. The general (note, not uniform) price rise of an inflation may be manifested in prices for some goods and services that do not fall as quickly as the supply/demand factors for said goods and services indicate, while others rise faster that the supply/demand factors indicate.

@LoneSnark, the quantity theory of money is a fallacy. Actually, the 9% increase in M3 may or may not be inflationary. Say, for the sake of argument, that the demand for money has increased 10% while M3 grew 9%. Can you truthfully say with certainty or even with a high probability said M3 growth was inflationary from the money measure by itself? Now, let's say that M3 didn't grow at all, but the demand for money fell 5%. In this case, the monetary situation *is* inflationary even though the money stock didn't grow. In both cases, no precentage rate of inflation can be deduced or inferred from the data given.

Gabriel, Not all inflation


Not all inflation is caused by “printing money” in order to steal from the private sector. Have you been hanging with Austrians?! The optimum rate of inflation is the rate at which potential output grows, i.e. new money needed for transationary purposes. Ypotential = M * v for the long run steady-state equilibrium.

This is nonsense even if you believe in the myth of the necessity of stabilizing prices against productivity advances.

Money is a scarce commodity. Every unit of money is always (every nanosecond) owned by exactly one someone (or one group or entity). Its unit exchange value will tend to increase if the total demand to hold money increases while the total supply of money remains the same.

If the time interval between workers' wage payments were doubled, then the average level of money holding by workers would tend to increase and an existing supply of money would be stressed, and therefore tend to result in an increase in the unit exchange value of money.

If the population actively involved in an economy increases, then the demand to hold money by the new participants will also tend to stress an existing supply of money, and tend to drive up the unit exchange value of money.

But no amount or level of transactions can be a stress on an existing supply of money as each and every transaction simply and instantaneously transfers money from one owner to another. IFF, and to a given extent, people tend to accumulate and hold money before making purchases, then an increase in the number and size of transactions will tend to have a statistical correlation with the demand to hold money, but the causative factor in any increase in the exchange value of money will be the demand to hold, and not the number and level of the transactions.

Regards, Don

The effects of monetary

The effects of monetary inflation are not uniform. That is a key fallacy that undermines inflationist and monetarist policies. All prices do not automatically go up as the Government dictates the rate of increase in money. (see Ludwig von Mises) Instead, only certain individuals and groups receive the benefit of excess money (currently mostly in the form of unbacked credit lent), who then derive the benefit of purchasing assets at pre-inflation prices. Only as the demand spreads does the effect manifest itself in prices of goods. The suckers at the end (mostly the poor and pensioners on fixed incomes) find that prices have gone up more than their fixed incomes. As an example, see the effects of FNMA and FHLMA on house prices.

To say that the price of oil is independent of monetary inflation seems wrong. US demand seems clearly to have flooded China with $, which has sparked their economy, much more petroleum based than ours, which has boosted their demand for oil, the supply of which is limited, particularly because refining capacity already was near 100%. Is there any doubt that US demand was sparked in great part by excessively low US interest rates? or by the extra cash provided by generous mortgage rates and refinancings? If not for China absorbing this demand with low-wage labor, would we not have seen the traditional price inflation effects in this country? Given these factors, is it not impossible to measure what part of price inflation is caused by monetary effects?

And that doesn't even address the risk of manipulation of your measurements for political purposes.

Am I the only one who is

Am I the only one who is confused by your definition of inflation? I always defined inflation as the actual act of increasing the money supply, not the subsequent price level increase.

And now that I think of it this confusion about the definition of inflation kind of answers your question. "Inflation," even by your definition, is an oxymoron when applied to one specific sector. But if we define inflation as simply the increase in the money supply, then we can look at economic phenomena as either across-the-board price level increases caused by inflation or isolated price level increases caused by changes in supply and demand.

@Charles D. Quarles My point

@Charles D. Quarles
My point was not that because the money supply is growing 9% a year we have inflation, I made an assumption that the demand for money wasn't growing 9% a year, are you suggesting my assumption was incorrect? If so, tell me why Americans need so much money nowadays. The population isn't growing that fast, national GDP isn't growing that fast, etc.

So, again, is it your contention that oil prices are driving the recent inflation rates instead of my suggestion: age-old monetary expansion?

Gabreil, Austrians just


Austrians just don't define inflation the way you do. Austrians don't believe that a general rise in prices is the proper definition of inflation, nor do they believe that such can solely occur due to the government "printing money". Mechanically one can achieve the same effect in other ways. The influx of silver into Holland around the time of the Tulip craze is one such mechanism.

Counterviening forces can also ameliorate any "printing of money" to prevent a rise in prices that would normally occur. Thus the deflationary pressures of opening of world to free trade has tended to counteract our current printing spree. Plus if other countries tend to start using our currency as a store of value that will also tend to be deflationary (on general prices). That doesn't mean the chickens will not come home to roost in the future. I expect if China and Japan see enough inflation they might want to reduce their holdings and that would teed to accelerate any effects.

Another way Austrians could see general prices falling is if the current situation in housing got out of hand and there were lots of defaults on loans. Of course, the expectation is that the government would not let this deflationary scenario happen as the political pressure would be too great. Thus, the government might be forced to open the spigot once again due to it prior round of monetary (not price) inflation.

If my understanding is correct the deposit insurance system we have is also monetarily inflationary if it should be triggered in any widesread manner. Should the current housing boom collapse and should that cause enough problems to trigger the insurance we will see quite a bit of monetary inflation that will eventually present itself a price inflation.

The fact that I make nearly ten times as much money as when I first started working is only partially due to a real wage increase due increased seniority and experience. Seeing how housing prices have increased five fold during the same period my real wages have probably only doubled or tripled. This price inflation is almost exclusely driven by monetary inflation caused by the government.

Austrian economics is much more complex than the stereotype of it that you have expressed here. Try reading "Human Action" or "Man, Economy, State" before you believe what you are told by other economists. I think Hewletts critique of Keynesianism should give you pause about believeing what the mainstream, government funded, economists have to say about this disciple.

Agreed that Bernanke is

Agreed that Bernanke is shifting blame, at least to a certain extent. My current thinking is that the impact of high energy prices on inflation is that high energy prices make it hard for the Fed to maintain their "dual mandate" of full employment and stable prices. To keep unemployment low, the Fed must keep interest rates low, which is inflationary.

Actually, blaming energy prices is probably "the right thing" for the Fed to be doing right now, because it gives them an excuse to print more money to keep the economy expanding. They can also blame energy prices for the economic downturn when commodity prices become too embarrassing and they have to allow rates to rise a bit.

The other way to look at it is that the definition of inflation Bernanke is using is that which is "measured" by the PCE deflator. High energy prices push this number up, hence we have inflation. Bernanke's definition of inflation has nothing to do with money, or with the Austrian definition of inflation (or perhaps even the Chicago school definition).

iceberg, While Rothbard may,


While Rothbard may, in context, not include an increase in gold itself as a part of inflation, it is clear that prices will tend to rise with an increase in the supply of gold.

What he could be pointing out is that the economic risk factor is much greater if a significant part of the money supply is made up of a fractional reserve bank credit expansion. If a borrower defaults on a fractional reserve loan, this results in a contraction of the money supply as the bank will likely be neither willing nor able to replace it.

However, if the entire money supply consists of gold or 100% backed claims to gold, then a default on a loan of gold will not result in a contraction of the money supply. The bank will lose its gold, but it will still exist in the hands of the suppliers of production factors that the borrowing firm has bought those factors from.

Regards, Don

LoneSnark, I thought that I


I thought that I had made it perfectly clear that the only way to get inflation was by manipulating the money, and that the quantity theories of money are fallacious.

The single datum, M3 increased 9%, tells you absolutely nothing other than this particular money supply measure (whether meaningful or not) increased 9% over some time interval. Neither do population increases or GDP increases tell you anything meaningful about what the demand for money may be in an economy.

Your assumption about the demand for money is where most people go wrong when looking at price increases for real goods or services (other than money itself, and interest rates reflect time and risk preferences unless they have been manipulated by governments/central banks). If market participants decide, and in the global economy these participants include people who aren't Americans, that they want to hold money at a 9% higher amount this year over last; then they will do so for whatever reasons that match their preferences.

We cannot measure inflation by prices. You would have a better chance of measuring inflation by asking people questions like: 1. Are you more or less willing to hold money now vs. last month, last year, last 5 years? 2. Are you going to be more or less willing to hold money next month, next year, next 5 years vs. now? 3. Do you think that the purchasing power is increasing or decreasing?

Whatever the CPI calls itself measuring, it isn't inflation. That is the point I'm trying to get across. It is the perception(s) and behavior(s) of market participants that count, not M3, not the CPI, not oil price increases, not GDP, nor any other factor outside of the willingness to hold money and the perception of purchasing power loss.