People often suggest that a fast growing economy is inflationary. I would argue that exactly the opposite is true. Consider this data for Venezuela and Singapore from an old Robert Barro textbook:
Venezuela (1950-90): Average RGDP growth = 4.4% Average inflation = 8.0%
Singapore (1963-89): Average RGDP growth = 8.1% Average inflation = 3.6%
Singapore grew much faster and had much lower inflation.
On the other hand, you might argue that I’m not holding “other things equal”. Actually, I did:
Venezuela (1950-90): Average money (base) growth rate = 10.7%
Singapore (1963-89): Average money (base) growth rate = 10.8%
Inflation is too much money chasing too few goods. Because Singapore produced lots more goods, the double-digit money growth created less inflation than a similar money growth rate in Venezuela. You might think of the faster RGDP growth as “absorbing” some of the extra money, leading to less inflation. BTW, the numbers don’t precisely add up because velocity also changes gradually over time. (Recall MV=PY, or m + v = p + y using rates of change.) But that doesn’t change the basic point. For any given money growth rate, faster RGDP growth leads to lower inflation in the long run.
Some might argue that long run increases in RGDP are not inflationary, but at cyclical frequencies an economic boom is still inflationary.
But even at cyclical frequencies the correlation between growth and inflation is unstable. Fast growth driven by an increase in aggregate demand is inflationary, while fast growth driven by an increase in aggregate supply is deflationary. That’s the basic AS/AD model. It’s why I keep saying “never reason from a price change” and “never reason from a quantity change”. (Compare inflation in the hot economy of 2000 and recessionary 1974.)
Paul Krugman has a piece in the NYT discussing various approaches to the Phillips Curve—the relationship between inflation and unemployment. The piece begins as follows:
It is a truth universally acknowledged — well, anyway, a truth acknowledged by everyone I know who thinks about the subject — that a hot economy leads to higher wages and prices. When demand for labor is strong, workers can and do demand wage hikes; when demand for goods and services is strong, businesses have “pricing power,” or the ability to raise prices without losing customers.
But does a hot economy lead to a higher level of prices? Or does it lead to a higher rate of change in prices, i.e., ongoing inflation? Or maybe even to accelerating inflation, a higher rate of change in the rate of change?
If a hot economy meant fast RGDP growth, then I would disagree. But in the second sentence Krugman defines “hot” as strong demand. So he’s not making the mistake I see so many others make.
But in that case, maybe we shouldn’t even be using inflation as our nominal aggregate when analyzing Philips Curve models. The relationship between inflation and unemployment depends on the cause of the inflation. Is the higher inflation due to more aggregate demand or less supply? A more useful nominal aggregate would be something like NGDP growth, which much more accurately tracks shifts in aggregate demand, and thus clarifies the real issue in the Philips Curve debate. It really is a truth universally acknowledged that a nominally hot economy leads to more inflation. And it also leads to more jobs (in the short run.) The profession made a serious mistake when it spent decades on macro models where inflation was the key nominal aggregate, instead of NGDP growth. (Both monetarists and New Keynesians are to blame.) The Phillips curve ought to look at the relationship between NGDP growth and unemployment. Do reason from a price times quantity (PY) change.
Even if we switch to NGDP, we still face the same sort of unresolved issues that Krugman wrestles with in his column. Is it the level of NGDP that matters? Or the growth rate? Or the change in the growth rate?
The answer is that all three matter. On average, the job market will be stronger with 6% NGDP growth than with 2% NGDP growth. But it’s also true that the job market will be stronger with 4% NGDP growth and the level of NGDP 2% above trend, than with 4% NGDP growth and the level of NGDP 2% below trend. In a sense, it is all about where NGDP is relative to expectations. But expectations formed when? That depends on the extent of wage stickiness. The longer that wages are sticky (i.e., the longer the duration of wage contracts), the longer the period over which NGDP expectations matter.
If one defines economic “hotness” as strong nominal demand, then the question of whether hotness leads to a one-time rise in inflation or a permanent rise in inflation is actually pretty simple. If you have a one-time increase in demand (NGDP growth) then you get a one time increase in inflation. If you have a permanent increase in NGDP growth then you have a permanent increase in inflation. It depends on monetary policy (broadly defined to include velocity.)
Some Keynesians wish to define aggregate “demand” as a real concept. I’ve seen graphs that conflate “demand” and real GDP, which makes no sense at all. Consider the AS/AD model. If the AD curve is stable and AS shifts to the right, then RGDP rises and prices fall. Do you want to call that an increase in “demand” just because consumers are buying more stuff? I’ve seen prominent economists do just that.
Here’s Krugman’s conclusion, which makes some good points:
Pessimists who insist that we’re doomed to years of high unemployment are basically asserting that we’re back to the inflation environment of the 1970s and early 1980s, that expectations have gotten unanchored and that to reduce inflation we’ll need to go through an extended period of unemployment well above the NAIRU.
I don’t agree; when I look at various measures of medium-term inflation expectations, they still look pretty anchored to me. But I could, of course, be wrong — the brief history of inflation theorizing I’ve just recounted doesn’t inspire much confidence that any of us has a really solid grip on the relationship between economic hotness (or coldness) and prices.
The point I want to make, however, is that you do need a theory. The evidence is fairly overwhelming that the U.S. economy is currently running too hot and needs to cool off. But how much cooling it needs isn’t a question that can be settled without deciding what kind of inflation process you think is currently operating.
HT: Ken Duda
READER COMMENTS
Thomas Lee Hutcheson
Jun 26 2022 at 4:09pm
But the NGDP target is chosen to maximize real GDP over time given both the positive and negative effects that inflation have, given the size of expected shocks. What does a NGDP-targeting central bank do when there are unexpectedly large supply or demand shocks — the 2008 financial crisis, petroleum prices, COVID? Can it do better than TIPS?
Thomas Lee Hutcheson
Jun 26 2022 at 4:21pm
And was it not weird that Krugman did not MENTION the Fed in the post? Even if aimed solely at wonky general education of NYT readers — the Lord’s work if work there was such — shouldn’t the lesson have included the Fed? And maybe changing ideas about what optimal inflation should be?
Roger Sparks
Jun 26 2022 at 11:41pm
The first mistake we might be making is to compare RGDP and inflation. This because the two measures do not compare equal data references.
Witness the high inflation found in the housing sector during a time that CPI inflation was modest.
I would argue the inflation as measured by the housing sector was caused by money supply increases. I would further argue that CPI inflation (during the same time period) was reduced by globalization of the supply chain assisted by exchange rate controls.
Still, we would like to use past data to predict future reactions.
The strange thing about the midyear 2022 economy seems to be the universality of destruction of basic relationships between economic components. Notice the near doubling of prices for fuel and fertilizer, two of the larger components of agricultural production and delivery. Notice also the roughly 25+% increase in the base price of labor which is the largest component of most farm production budgets.
Add ‘war in the Ukraine’ to the disruptive list and you can begin to see the many sources of chaos that are at play in today’s economic world.
Scott Sumner
Jun 27 2022 at 1:03pm
I’d go even further. It’s not just the CPI that can be misleading; no measure of inflation is a useful concept in macroeconomics. The Fed should focus on NGDP growth.
vince
Jun 27 2022 at 7:53pm
Realistically, what control does the Fed have over NGDP? Powell recently had to tell Congress repeatedly that macro problems such as unemployment are largely fiscal policy, not monetary policy.
Scott Sumner
Jun 28 2022 at 12:33pm
In the long run, they have total control over NGDP and almost no control over unemployment.
vince
Jun 28 2022 at 12:39pm
That deserves a better explanation. If they have little control over unemployment, they have little control over production, the P in NGDP. Maybe you are saying they can control NGDP by inflation. But as you mentioned, no measure of inflation is useful.
Scott Sumner
Jun 28 2022 at 7:41pm
The P in NGDP is nominal production. Unemployment depends on real production. I’d encourage you to read my new book, entitled “The Money Illusion”.
Thomas Lee Hutcheson
Jun 29 2022 at 10:08am
Powell may have told them that, but he was mistaken.
vince
Jun 29 2022 at 11:38am
An example of why economics is a Tower of Babel:
“Powell recently had to tell Congress repeatedly that macro problems such as unemployment are largely fiscal policy, not monetary policy. ”
Hutcheson: “Powell may have told them that, but he was mistaken.”
Sumner: “In the long run, they have total control over NGDP and almost no control over unemployment.”
Spencer Bradley Hall
Jun 27 2022 at 9:16am
Lending by the Reserve and commercial banks is inflationary (increases the volume and turnover of new money). Lending by the nonbanks is noninflationary – other things equal (activating existing funds, a velocity relationship).
The utilization of savings is a catalyst, has a positive economic multiplier. The injection of new money has a negative economic multiplier. QE forever, in conjunction with the payment of interest on IBDDs, decreases the real rate of interest.
Lizard Man
Jun 27 2022 at 12:34pm
How do deviations from expected NGDP growth harm the economy? Do they increase risk or introduce uncertainty, and hence lead to lower investment because firms are less sure what kind of prices they will be able to get? What are other pathways that deviations from trend impact the real economy?
Scott Sumner
Jun 27 2022 at 1:05pm
The main cost is that unstable NGDP distorts the labor market, causing business cycles. Another problem is that they create credit cycles, including occasional financial crises.
High trend rates of growth in NGDP also discourage saving and investment.
Lenny
Jun 29 2022 at 2:48pm
Bear with me on this – I’m coming at this from outside the profession so to speak. In comparing Venezuela and Singapore; if growth in money supply is about the same, wouldn’t the difference in inflation be at least partly explained by a difference in general productivity improvements, since improving productivity tends to reduce general price levels?
Or is that just another way of saying there is a difference in RGDP without adding anything?
The reason I ask is that I visited both places in the early 90s and there was ample anecdotal evidence of a difference in productivity; bureaucracy, restrictions on businesses, etc. How does this get taken into account in this type of analysis?
Scott Sumner
Jun 30 2022 at 1:19am
“In comparing Venezuela and Singapore; if growth in money supply is about the same, wouldn’t the difference in inflation be at least partly explained by a difference in general productivity improvements, since improving productivity tends to reduce general price levels?”
Exactly.
Sina Motamedi
Jul 17 2022 at 10:13pm
Another seminal post, Scott. Thanks.
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