neutral inflation/real inflation

Over at Econlog, I have a new post pushing back against the view that inflation is caused by “global factors” such as economic slack. I point out that the UK and Switzerland have faced the same global factors since 1971, but have had vastly different inflation rates, due to vastly different monetary policies.

This confusion is actually a symptom of a deeper problem, the tendency of many economists and other pundits to view inflation as a sort of “real phenomenon.” At a fundamental level, inflation is nothing more than a change in the value of the medium of account, sort of like switching from using feet to using meters. It doesn’t change the size of objects being measured. People in Turkey and Argentina have adjusted to inflation that is higher than in India, and Indians have adjusted to inflation that is higher than in the UK, and the Brits have adjusted to inflation that is higher than in Switzerland.

In the 1980s, Americans easily adjusted to 4% inflation, as their wages rose faster than today. The economy was not “overheating”.

In the short run, unexpected changes in inflation can have real effects on output due to wage/price stickiness, nominal debt contracts, money illusion, etc. (It’s as if the size of the objects being measured changed as a result of switching from feet to meters.) The mistake many people make is to work backwards from these short run real effects and assume they actually cause the inflation (or deflation)!

No, no, no, a thousand times no! An overheating economy does not cause inflation. Economic growth is deflationary. Rather, higher than expected inflation can cause an economy to overheat. But you can also have high inflation without any overheating at all, indeed even with lots of “slack”.

Inflation is caused by monetary policy, and that monetary inflation might or might not have a wide range of real effects associated with it, depending on all sorts of contingencies. If I read that Argentina has 20% inflation, I don’t immediately think “overheating”, I think “printing money to pay the bills.”

Many New Keynesians rely on models where inflation is associated with some sort of overheating. In fairness, those models generally have some sort of natural rate component, and include expectations of inflation. They are still “reasoning from a price change”, and thus highly flawed, but at least they understand that money is neutral in the long run and that economic slack doesn’t explain long run changes in inflation.

Old Keynesian models are even worse (and AFAIK) this also applies to MMT. They simply assume that inflation is not a problem as along as there is economic slack. Milton Friedman once said that in 200 years we’d merely gone one derivative beyond Hume. Unlike the monetarists and New Keynesians, lots of pundits and economists still haven’t even incorporated the first derivative into their models.

And while looking at changes in inflation is better than looking at the absolute level of inflation, it’s still not good enough. It’s still reasoning from a price change. We need to focus on changes in NGDP growth, which may or may not have real effects, depending on all sorts of factors. But at least with a model of:

Monetary policy —> NGDP —> inflation/unemployment/RGDP

we are on the right track.

If you begin with:

Economic slack —> inflation/deflation

then you aren’t even on the right track.

PS. Consider the following scenario. During an economic recovery, RGDP grows as 3% as unemployment falls rapidly. Once full employment is reached, growth slows to 2% and unemployment stabilizes. A soft landing. Now assume NGDP grows at 5% throughout this entire period. What happens to inflation?

Inflation would rise from 2% to 3% once we had reach “full employment.” But this is NOT at case of strong growth pushing inflation higher, indeed in my example the rise in inflation was caused by a slowdown in economic growth (given the stable path of NGDP.)



21 Responses to “neutral inflation/real inflation”

  1. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    3. March 2019 at 08:19

    ‘…inflation is nothing more than a change in the value of the medium of account…’

    Actually, a change in the ‘price’ of the medium of account.

    If a store is selling bread at $1 per loaf, the price of a dollar is one loaf of bread. Then, if the central bank doubles the money supply, and the price of a loaf of bread doubles to $2, the price of a dollar is cut in half (to 1/2 a loaf of bread).

  2. Gravatar of Scott H. Scott H.
    3. March 2019 at 09:04

    “This confusion is actually a symptom of a deeper problem, the tendency of many economists and other pundits to view inflation as a sort of “real phenomenon.””

    This is also why people pointing to a single item or single group of rising prices and declaring it proof of inflation are so wrong. Because inflation is not a real phenomenon it is also not a limited phenomenon. The 70’s were so long ago that most people in the USA have never witnessed easily perceptible inflation.

  3. Gravatar of dtoh dtoh
    3. March 2019 at 10:12


    I would break inflation into two components. A hysteretic component or a base rate of inflation that people have come to expect and is built into their behavior, and a dynamic component which is manifested in changes to the underlying base rate of inflation.

    In my view changes to the underlying base rate of inflation are caused by expectations of a short to medium term future imbalance of supply and demand.

    A more accomodative monetary policy drives demand, and if the economy is already at or near full capacity, there will be a supply demand imbalance which will push inflation up.

    I’m not sure what you mean by “overheating” in the economy. Could you define this. Also I don’t think you can use the real growth rate as a good proxy for whether the economy is at capacity (or full employment.)

    Finally, I believe today’s economy can increase supply for most things at a much faster rate than in the past, and the increased supply is much less dependent on the labor supply than it used to be.

  4. Gravatar of Matthew Opitz Matthew Opitz
    3. March 2019 at 10:19

    I agree that inflation has little to do with slack in the economy.

    However, I’m a fan of a different theory of how monetary policy causes inflation: a Sproulian backing theory of fiat money’s value. I.e. fiat money still has its value determined by the assets (and ultimately, commodities associated with those financial assets) that are backing each unit of fiat money, as long as any redemption channels remain partially open or are expected to open in the near future (such as when Britain suspended the redemption of British pounds for gold during the Napoleonic Wars, albeit with the credible expectation that redemption would resume when normal circumstances returned).

    While I don’t claim that this can explain month-by-month flucations in the inflation rate, over the long-term I think inflation results insofar as the Fed’s balance sheet deteriorates. This can happen when long-term interest rates rise (which devalues the existing lower-interest bonds on the Fed’s balance sheet), when the monetary authority feels pressured to buy toxic assets for more than they are actually worth in order to accommodate the banking system’s desire for additional reserves (i.e. putting not-sufficiently-backed base money into circulation, which happens to a small extent even in normal times, hence 2% inflation, and which happened to a large extent during the QEs which would have led to inflation if not for the simultaneous drop in interest rates), whenever the value of the monetary authority’s assets are put into doubt (such as, in the U.S., the extent to which it looks like Congress might one day choose to default on some of the Treasury’s debt), and of course the most egregious case where the monetary authority simply creates electronic or paper high-powered money without even the pretense of acquiring any additional backing whatsoever (Venezuela).

    I’ve built a model that explains the historical dollar-price of gold reasonably well that relies on discounting the non-gold asset side of the Fed’s balance sheet by varying percentages in order to account for the factors above, and then seeing how much of the Fed’s liabilities are canceled out by this remaining non-gold asset figure, and thus how many Federal Fund dollar liabilities remain to be compared with the Fed’s gold assets (which I value not according to the legal fiction of how much in dollars the Fed has in gold certificates, but in the weight of gold holdings on the government’s consolidated balance sheet, i.e. what the Treasury actually owns).

  5. Gravatar of Scott Sumner Scott Sumner
    3. March 2019 at 10:39

    Patrick, Yes, in a sense it’s the price. But there is a different price for each good, so “value” might be less confusing.

    Scott, Agreed.

    dtoh, I’d rather say unexpected inflation causes S&D imbalances if wages and prices are sticky, rather than results from them. If wages and prices are not sticky, you can still get unexpected inflation, even w/o any supply/demand imbalances. So imbalances are not fundamental.

    You said:

    “Finally, I believe today’s economy can increase supply for most things at a much faster rate than in the past,”

    Actually, just the opposite is true; productivity growth is slowing.

    Overheating is usually defined as an unemployment rate below the natural rate.

    Matthew, The backing theory doesn’t explain variations in the rate of inflation for a fiat money economy with sound public finances, such as the US since 1968.

  6. Gravatar of Michael Sandifer Michael Sandifer
    3. March 2019 at 12:05

    As I understand it, the change in the inflation rate will be proportionate to the change in the expected growth of the money supply versus the expected growth of output, otherwise holding demand for money constant.

    Demand for money is usually determined by changes in the expected growth of the money supply versus expected output growth, with the exception of overseas demand for dollars, which can be in response to overseas macro factors.

  7. Gravatar of dtoh dtoh
    3. March 2019 at 12:09

    Inflation causes S&D imbalances? Or uneven inflation (some wages/prices raising faster than others) causes S&D imbalances?

    Can you explain the mechanism by which you get a change in inflation without S&D imbalances.

    Not sure aggregate productivity is what matters for increasing supply without labor. Isn’t the marginal productivity of capital what matters?

  8. Gravatar of dtoh dtoh
    3. March 2019 at 12:11

    What’s the current natural rate of unemployment?

  9. Gravatar of Rein Rein
    3. March 2019 at 12:59

    I might be going off topic here but I don’t really get it. If NGDP = AD (right?), and AD is everything a central bank should and can control, why is NGDP targeting not widely accepted? Where does this disagreement come from?

  10. Gravatar of Benjamin Cole Benjamin Cole
    3. March 2019 at 16:40

    This blog post is probably correct.

    On the other hand, there is inflation as measured.

    Surely, people living along the West Coast have faced a different rate of inflation than people living inland over the past couple decades.

    Anyone who is renting on the West Coast is faced continual increases in housing costs.

    I understand that people along the West Coast have faced is a decline in living standards, and not inflation in a monetary sense. Nevertheless, during this time, inflation as measured must’ve increased along the West Coast due to housing costs.

    Similarly, George Selgin has posited that an agricultural economy can have inflation, even if not validated by monetary policy, as during a crop bust. A basic commodity becomes scarce, and prices rise.

    Conversely if less-expensive imports continuously grab a larger share of domestic manufactured product sales, you would see a decrease in measured inflation that persists for several decades.

  11. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    3. March 2019 at 16:43

    ‘But there is a different price for each good, so “value” might be less confusing.’

    Value is inchoate, price is objective reality. BTW, Milton Friedman liked my formulation when I tried it out on him.

  12. Gravatar of ssumner ssumner
    3. March 2019 at 19:35

    dtoh, If the change in inflation is expected, there need be no S&D imbalances.

    I don’t know the current natural rate of unemployment.

  13. Gravatar of ssumner ssumner
    3. March 2019 at 19:36

    Patrick, How do you objectively measure the price of money?

  14. Gravatar of Jeff Jeff
    3. March 2019 at 22:00

    How do you objectively measure the price of money?
    The inverse of a broad-based price index.

  15. Gravatar of dtoh dtoh
    4. March 2019 at 02:22

    Scott, Under what circumstances do people expect a uniform change in the inflation rate other than in Zimbabwe like conditions where there is a history of accelerating inflation.

    For a uniform change to occur, everyone would need to expect the change…..not just Fed watchers.

    In an economy with relatively constant single digit inflation, I have a hard time seeing how inflation is driven by anything other than actual S&D expectations.

  16. Gravatar of ssumner ssumner
    4. March 2019 at 05:58

    Jeff, I get that, but how do you measure the price level? Price indices are certainly not “objective”. No one has even clearly explain what price indices are supposed to measure.

    dtoh, The question of whether S&D imbalances are associated with changes in inflation (usually) is very different from the question of whether they cause changes in inflation. Monetary policy causes changes in inflation, not S&D imbalances.

  17. Gravatar of Brian Donohue Brian Donohue
    4. March 2019 at 06:17

    “Cost of living” is a subjective, personal thing. Changes in relative prices keep people’s “cost of living” in flux all the time.

    Inflation is systemic background stuff. At low levels, it’s hard to see in the face of constantly fluctuating relative prices.

    At 20%, it’s easy to spot. But it’s the same thing in either case. Moar currency.

  18. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    4. March 2019 at 08:03

    ‘Patrick, How do you objectively measure the price of money?’

    I already showed you how. What exchanges for money is the ‘price’. Milton saw it right away when I proposed it to him. As does his son;

    ‘One way of describing such a situation [inflation] is to say that the money prices of apples, oranges, houses, cookies, and many other things are going up. A simpler way is to say that the price of money is going down. If apples used to cost $.50 and now cost $1, then the price of a dollar has fallen–from two apples to one. ‘

  19. Gravatar of dtoh dtoh
    4. March 2019 at 09:06

    @scott ” Monetary policy causes changes in inflation, not S&D imbalances.”

    Yes monetary policy causes changes in inflation through the mechanism of stimulating (or depressing) demand which results in S&D imbalances causing inflation.

    The hot potato mechanism is not correct. Monetary policy works through an exchange of money for financial assets. Money does not fall out of the sky.

  20. Gravatar of ssumner ssumner
    5. March 2019 at 14:08

    Patrick, But then there are many prices of money, which doesn’t seem useful to me. I’d prefer to use a price index, which itself is full of flaws.

    dtoh, Think of it this way. Suppose there is rent control in NYC, which freezes rents for 12 months after a new lease, and then allows unlimited increases. A sudden removal of housing units (from flood damage) causes higher equilibrium rents, and this would occur even without any disequilibrium from rent controls. But the rent controls cause temporary shortages, as actual rents don’t raise as fast as the equilibrium rent. Nonetheless, I would not say the shortages CAUSE the rise in rents, rather they are just a bump in the road, and the supply reduction would have caused rising rents even if the rental market was 100% efficient, with no price controls and no shortages.

  21. Gravatar of Scott Sumner on inflation and economic slack | Andrew Gillen's Blog Scott Sumner on inflation and economic slack | Andrew Gillen's Blog
    9. March 2019 at 03:18

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