I frequently argue that inflation doesn’t matter, and that NGDP growth is usually a more appropriate variable to use when you need a nominal indicator. One commenter recently argued that inflation is useful in calculating real interest rates, and that real interest rates determine whether people are motivated to borrow and lend.
I certainly understand that real interest rates are often better indicators of credit market conditions than nominal rates, but is the nominal rate minus inflation necessarily better than the nominal rate minus per capita NGDP growth? To think about this issue, let’s consider an extreme case, where the rate of inflation is very very different from the rate of NGDP growth. Then think about which variable seems more meaningful to people making decisions whether to borrow or lend.
In my example, I’ll assume a stable population, no inflation and 18% NGDP growth. Let’s assume a 7.2% interest rate, although the exact number doesn’t matter. I want the interest rate to be much higher than inflation and much lower than NGDP growth, to see which one seems to matter more. Now consider someone who earns $40/hour contemplating the decision to save $40, by lending it to someone for 20 years. What does this look transaction like in real terms?
Since the real interest rate is 7.2% (due to zero inflation) the money will double every 10 years, or quadruple over 20 years. That means you’ll get back 4 times more goods and services than you lent out. Seems like a pretty good deal for savers, right?
But let’s think about this in terms of a loan of work effort. At 18% NGDP growth, and no inflation, real GDP will double every 4 years, and increase 32-fold over 20 years. In 20 years, you will be able to produce as much in 2 minutes as you now produce in one hour. So that 4-fold real rate of return is actually just 8 minutes of output in the year 2036. You are giving up one hour’s worth of output, and getting back 8 minutes of future output. That doesn’t sound very appealing. Your rate of return in terms of goods able to be purchased in an hour’s worth of work is negative 10.8%. Instead of lending the money out, why not just work an hour less today and 8 minutes more in the future? Or alternatively, work just as much today and don’t worry about 20 years from now, as you’ll be really rich by today’s standards.
What this example tries to illustrate is that the real interest rate that matters to savers is not the nominal rate minus price inflation, it’s the nominal rate minus wage inflation. Which is roughly the nominal rate minus growth in NGDP per capita.
So once again we find that inflation doesn’t matter.
PS. In about 30 minutes I’ll have a new post at Econlog, on the recent market gyrations.