Tuesday, July 16, 2024
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I ask a stupid question…

by xyonent
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. . . is the stupid answer.

A recent article on inflation beautifully illustrates the truth of this old adage: Before reading this article, let’s review one more adage, which is not outdated at all.

Never judge a product based on a change in price.

For example, it makes no sense to ask people about the “welfare costs of inflation” without specifying whether the inflation is due to a decrease in supply or an increase in demand, but nothing stops pollsters from asking the question. economist (From the article “Is Inflation Morally Wrong?”):

Americans who responded to Stancheva’s survey were angry for a variety of reasons. Most thought inflation necessarily meant lower real incomes; they said they worried that rising prices would make life harder for them and prevent them from affording basics. Respondents didn’t see a trade-off between inflation and unemployment (what economists call the “Phillips curve”), but instead thought the two would rise in tandem. About 70% saw inflation as a sign of “poor economics” rather than a sign of a booming economy.

Notice that all of the public’s beliefs are true if inflation is caused by a supply shock, and false if it is caused by a demand shock. Compare these views with those of economists.

So why are some economists more tolerant of rising prices? Inflation certainly poses difficulties. It can undermine the credibility of central banks and trigger arbitrary redistribution from creditors to debtors. And constant price updates are costly to businesses. But if all prices adjust at the same rate, the changes are not as significant as many workers think. Inflation does not mean that workers are becoming poorer, any more than measuring someone’s height in feet instead of centimeters means that he or she is shrinking. Moreover, inflation is often the result of a booming labor market.

Note that economists’ views are mostly accurate when inflation is caused by a positive demand shock, but are rather misleading when it is caused by a negative supply shock.

It’s not that the public and economists disagree about inflation. Rather, they argue: A completely different conceptThat’s like conflating a fall in the price of coffee because of a caffeine-induced cancer scare with a fall in the price because of a bumper crop of coffee beans: the effects on consumer welfare are not the same.

Consider two views that are widely held by many people:

1. People hate high inflation.

2. An independent central bank is necessary because politicians are tempted to implement expansionary monetary policies in order to gain popularity.

Do you see the contradiction? This puzzle can be solved, or at least greatly reduced, if we distinguish between supply-side and demand-side inflation. Clearly, people hate supply-side inflation because it is associated with lower living standards. There are cases where demand-side inflation is also somewhat unpopular (like now), but this case is much more murky. Here are some counterexamples:

1. From 1929 to 1933, austerity measures reduced the cost of living by about 25%. However, President Hoover was extremely unpopular.

2. From the spring of 1933 to the spring of 1934, FDR’s expansionary monetary policies caused the cost of living to rise by about 10% (higher than peak inflation in 2022). FDR was extremely popular.

3. In 2008-2009, tight monetary policy caused inflation to fall sharply to almost zero. People viewed the economy as in decline.

These three unusual cases in which public opinion moved “in the wrong direction” in response to inflation changes have one thing in common: in each case, the inflation change was caused by a demand-side shock. This reflects the view of economists that economist This article is not to say that demand-side inflation is always popular (it isn’t), but rather that the welfare effects of supply-side inflation and demand-side inflation are very different, and people can feel this difference at least to some extent. For example, supply-side inflation reduces real income, while demand-side inflation temporarily increases real income (i.e. real GDP).

Many at the Fed think that NGDP targeting is a bad idea. One argument you often hear is that the public understands inflation targeting, but not NGDP targeting. This couldn’t be further from the truth. NGDP targeting is much easier to explain to the public.

Fed officials who are under the delusion that the public “understands” Fed inflation targeting should go to town meetings and explain that if inflation falls to 1%, the Fed is working hard to raise inflation to 2% (or even 3%, like FAIT). Look at the incredulous looks on their faces. Sure, some people have vaguely heard about the Fed’s 2% target, but they assume it means that the Fed is trying to keep inflation from exceeding that level. Fewer than one in a hundred people understand the true nature of inflation targeting, which is that 2% inflation is actually a good thing, and that if inflation falls below that level, the cost of living needs to be controlled. It will rise even faster.

One might argue that NGDP suffers from the opposite asymmetry, that is, the public doesn’t understand why excessively high growth in NGDP is a bad thing. In fact, the asymmetry in NGDP isn’t really a problem. It takes a PhD in economics to really understand why higher inflation reduces unemployment. (And even that might not be enough.) Inferences from price fluctuationsOn the other hand, if you tell ordinary people that a rapid increase in national income could lead to problems with high inflation, they will understand to some extent.

The Fed needs to tell the public that monetary policy is not about interest rates, inflation, or unemployment. Monetary policy is aimed at keeping national income growing at 4% per year. Period.

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