Tuesday, May 20, 2008


Yves (I find this guy so useful I feel like his cyber-cousin or something) has a couple of contrasting views about inflation posted today. I wanted to use it as an excuse to order my own fuzzy thinking about inflation.

I guess I'm still a monetarist, meaning that I believe that inflation (a rise in the price of almost everything, not just gasoline) cannot happen without an increase in the money supply. Conversely, an increase in the money supply will typically cause inflation, though this second proposition seems more complicated to me. I need to do some more reading on it, but I don't even see any other coherent way of looking at it -- if you're not a monetarist then what are you?

As a monetarist, I imagine the money supply of the world as a set of imperfectly communicating lakes. It's not just one giant ocean of money because each country prints its own currency, maintaining its own separate lake. These lakes do have flows between them though, determined by the exchange rates. This is why you can get increasing money supply in just one lake, or inflation in just one country. The country prints some money, the general price level goes up, but any new flows out of that lake don't increase the level of other lakes because they translate into less foreign water (so to speaks) as the value of the currency of the inflating country plummets. So the US prints more dollars, which causes US inflation, but does not cause world inflation because the value of each one in terms of other currencies goes down. The same amount of foreign currency buys more US dollars, so there's no need to print more foreign currency to compensate. The exchange rate acts like a shock absorber of sorts, that prevents 'inflation contagion' and keeps the lakes separate rather than forming one big sea. Presumably the attractiveness of a particular lake is related to its level of real interest rates.

Unfortunately, in the real world not all currencies float freely, and the lakes do not communicate in this seamless fashion. Some people (Argentina, China, Saudi Arabia, etc ...) peg their currency to the dollar. This means that when the US prints more dollars, they can flow directly into the money supply of these other countries. Currency peg countries overcome the natural communication mechanism of the exchange rate market by printing more currency of their own so that the relative value doesn't change. This means now that the level of several lakes goes up, and for geo-political reasons we end up with a worldwide inflation contagion because many people follow behind the US in increasing the money supply.

Simple, ¿no? The thing that complicates this picture for me, and that I don't yet understand, is that the newly minted money can go to pay for either products or assets. People only seem to count it as inflation when it increases the prices of products, though I'm not sure if this is justified. It seems to me that it is at this point, in deciding where the new money supply will push up prices, that you have to get into questions of the competitive landscape, of 'cost-push', of the balance between labor and capital, and the wage-price spiral. These questions seem perfectly real, I just see them as second order, logically speaking.

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