Inflation and Monetary Theory
Jim Blair

Two introductory thoughts:

"Fortunate is the man who can understand the causes of things" - Virgil

And from George Orwell, an idea that he expressed in an essay on the nature of language, and again in his novel 1984. The idea that the words we use, and the way they are defined, shape the way we think about reality. (But of course they don't change reality.)

What is the reality? And how is it measured?

There are several examples from the history of science where there was little progress in a field until the proper formulations and definitions were established. In thermodynamics for example, the distinction between "heat" and "temperature", or in chemistry the difference between a compound (uniform and fixed proportions of elements) and a mineral (with a range of proportions of elements).

In a similar manner there is a problem in economics over the concept of inflation/deflation. What are they, and how are they measured? When I was in college (and before that I think) inflation was considered to be an increase in the money supply that was "too fast". But the problem was "faster than what?" The money supply was supposed to expand. But just not "too fast" or "too slowly". "Too fast" was inflation; "too slow" was deflation.

In those days, an increase in prices was the expected result of a period of inflation, and was a consequence of the inflation.

Sometime during the 1970's, there was a shift in thinking. A general rise in prices was taken to be not the result of inflation, but the definition of inflation. The Consumer Price Index (CPI) was formerly considered to be a crude estimate of inflation because it was a measure of the price change in a fixed "basket" of common goods. But with the shift in thinking, the CPI change became the actual measure of inflation.

And many contracts contained Cost Of Living Adjustment (COLA) clauses, which transformed the CPI from a tool of economists to a political device where millions of dollars would change hands with every slight change in its published value.

But the CPI has an bias to overstate inflation: see the Boskin Report and "Why You Should Be Alert in Econ Class" on my web page . As long as the inflation rate was "really" greater than the CPI bias, there was no problem with considering the CPI to be the measure of inflation (except that economic growth and wage figures were understating reality).

But for the past several months or maybe a year, I suggest that the "True" rate of inflation has dropped below the CPI bias, and that while the CPI is still rising (indicating mild inflation) the reality is a mild deflation. And (with so many other currencies linked to the US dollar), this is the main cause of the economic problems in much of the world.

What to do next?

The immediate solution is for the Federal Reserve to cut the discount rate, probably by about 0.5%. See "Jack Kemp on Gold & World Deflation".

The longer range solution is to find a better indicator of inflation and deflation than a price of goods index. Besides a bias, any price of goods index will be "behind the curve" in that it will take time to react to changes in inflation/deflation.

Monetary Theorists have said to use the money supply as the measure of inflation. It should grow at a "fixed" rate, along with the economy. But this is not so easy, what with credit cards and banks making loans. The control that the Fed has over the money supply is probably too "indirect" for this to work well. And besides it is not just the supply of money that matters, but also the rate that it exchanges that will determine if there is "too much" or "not enough" of it. A dollar that is spent by someone every day has 7 times the impact on prices as one that is spent only once a week. Remember MV = PT ?

And Monetary Theory offers no way to deal with or to control the turnover rate of money (V in the above equation).

The "gold bugs" have a different answer: regulate the interest rates, and buy or sell government securities, so as to keep the price of gold (true money) at a fixed level. The price of gold is the result of both the supply and the demand for both gold and dollars. That is, it factors in both the amount of money and the rate that the money exchanges.

For more on this see the Gold Polaris at http://www.wanniski.com/ssu.asp.

I used to think that Milton Friedman and the monetary theory crowd had the right idea: Keep the money supply from expanding, and inflation can be controlled. Just don't print money faster than a fixed rate.

But lately (mostly as a result of reading the posts and web page of William Hummel), I am having doubts about this. I mean with credit cards and checks, people don't even need any "money" to buy things.

Or to say it differently. just what is "money" today? My credit card limit is $10,000. Is that just like having 10 grand in my wallet? The limit was recently raised to $10k from $2k. Did that move expand the US "money supply" by $8,000? And the credit card company did it, probably without even asking Alan Greenspan.

The Federal Reserve can do things to "restrict the growth of the money supply", mostly by raising the re-discount rate, but this is much less direct than "stopping the presses".

There is some discussion of this on my web page's Money & Inflation section at http://www.geocities.com/capitolhill/4834/cpi.htm

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