Tuesday, 18 June 2013

Inflation and the Long Run

Milton Friedman is known for the famous monetarist aphorism "inflation is everywhere and always a monetary phenomenon", a doctrine which has been fed to a whole generation of economists, especially in the US. Monetarists believed that in any case, inflation is, in the long-run, determined by the rate of change of the money supply. Nevertheless, this has not been the case even in Friedman's time, and it will never be so in ours.

First of all, let us determine what we mean by money supply. Usually, depending on what measure we use, we either mean the monetary base (i.e. the amount of money circulated by the government) or the monetary base plus the amount of money held at banks, depending on the measure we wish to employ. The amount held by banks is usually the result of bank credit, i.e. bank-created money through the process of the money multiplier. Although during Friedman's time, money supply usually meant the monetary base, the case holds even if we use the broader measures.

As stated in the last article, money supply and bank credit make up for much of the inflation in a country. Nevertheless, they do not make up for all of it, neither do they determine the final rate. The famous "in the long run" statement does not hold for such issues. The long run is always determined by the short- and medium-run. For example, let us assume that we raise the money stock in the economy by 1% per year over the next 30 years and we expect that to be the long-term inflation rate. Even if we use the average of those years, then we would not end up with just a 1% inflation rate. 

The reason is relatively simple: the long-run has the short- and medium-run embedded in them. Using our previous example, we would expect that in 2043, our average 30-year inflation rate would be 1%. Yet, in the past 10 years, i.e. the medium term, we might have experienced a recession or a depression, which lowered the velocity of money, the inflation rate would have been significantly lower than what we expect. Data for the United States, obtained via the St. Louis Federal Reserve, indicate something similar for the 29 years from March 1984 until April 2013.

The simple average of the monthly change in inflation over the past 29 years was approximately 0.23%, while the monetary base grew by an average 0.56% and the broad M2 money measure by 0.46%. As the data indicate, the change in inflation is about half the change in all other measures. Not even the MZM measure, which is supposedly better in predicting inflationary powers, fares any better: it's average is 0.61%, far greater than the rest and about 2.5 greater than the actual inflation rate. 
Many readers, on observing the spikes on the monetary base, may be inclined to treat them as outliers and comment that without them, the situation might have been just like Friedman described it. I beg to differ. Those outliers are exactly the outcome of a world without a steady state, with large deviations from a stable equilibrium (if one exists), forcing economists to realize that their predictions and remedies might not work in the real world. If, in the case of the monetary base, we excluded all observations which are in excess of 1% as being outliers, we would effectively eliminate approximately 30% of the observations. Thus, one may safely conclude that either our sample is erroneous (which is not the case here) or that the "outliers" are an important part of our world.

Concluding, although money supply can assist us in explaining inflation rate, it does not tell us the whole story, as data indicate. A simple explanation is that money needs to be spent in order for inflation to be affected. Even  if the government prints money or if banks create more credit, if people are still afraid to spend because they feel the need to save more for the future then inflation is not affected. Policy-wise, it is not enough to make people not willing to keep their money in a bank. In order to move from depression to growth you have to persuade them to spend as well.

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