Inflation and relative prices | AIER

This article was originally published in economic forces Newsletter.

I want to continue my previous mail about inflation, tying together the many topics that Brian and I discuss on economic forces. Our newsletter is mostly about price theory, so it might seem strange that I want to spend so much time writing about inflation, which is a macroeconomic topic. However, I think this is a misconception. This is partly due to the way economics is taught, clearly dividing subjects into microeconomic topics and macroeconomic topics. In fact, everything in economics is just price theory.

If so, what does inflation have to do with price theory? Isn’t price theory based on relative prices, while inflation is based on money prices?

Well, when we think about inflation, we need to think about monetary expansion. After all, inflation is always and everywhere a monetary phenomenon. As I discussed in my previous mail, there is such a concept in macroeconomics of classical dichotomy. The idea is that nominal variables affect nominal variables and do not affect real economic variables. Money exists only for accounting purposes. Relative prices are all that matter in the distribution of goods and services, and the classic dichotomy is that money has nothing to do with relative prices.

If the classical dichotomy is correct, then inflation would be literally just a monetary phenomenon and would have nothing to do with price theory. An increase in the money supply will raise the price of money, but not a change in relative prices. Of course, the classic dichotomy doesn’t work—at least not in the short term. Monetary factors affect real economic activity. In fact, virtually every theory of how monetary policy works emphasizes changes in relative prices.

Monetarists argue that open market operations cause a relative increase in bond prices, which causes a number of portfolio effects, raising the prices of financial assets, which reduces the relative price of real assets and therefore increases investment. Austrian economists stress that the relative effects of prices will depend on how new money is introduced into the system and who gets the new money first. New Keynesians believe that some prices are flexible while others are slow to adapt. Thus, an expansionary monetary policy leads to higher relative prices for those goods whose prices are the most flexible.

Each of these theories has different implications for understanding monetary policy, the business cycle, and inflation. What all these theories have in common, however, is that an expansionary monetary policy not only causes inflation, but also has at least a temporary effect on the economy. relative Prices.

This point is important because it can help us understand the costs associated with inflation.

Many macroeconomic discussions in the popular press are rather flippant about the topic of inflation. People will casually argue that the inflation target should be 3 or 4 percent rather than the Federal Reserve’s preferred 2 percent target. These claims are based on the notion that higher inflation means higher nominal interest rates, which gives the central bank more room to pursue expansionary policies and reduces the likelihood that policymakers will have to deal with the problem of a zero-lower bound on nominal interest rates. .

Of course, price theory tells us that the optimal rate of inflation is that at which marginal benefit equals marginal cost. To the extent that higher inflation gives central banks more flexibility, this can be beneficial. But what about cost?

Most economists who are asked about the costs of inflation will focus on inflation as something like a tax. People will choose to hold so many dollars that the marginal benefit of the last dollar they hold equals the marginal cost. The ultimate benefit of owning dollars is that they make transactions easier. Marginal cost is the opportunity cost of holding dollars instead of some other store of value. Since physical currency does not earn any interest, the opportunity cost of holding these dollars is the nominal interest rate on a risk-free asset.

However, from a social perspective, maximizing social welfare would require that the marginal social benefit equals the marginal social cost. The marginal social cost of producing an extra dollar is zero. Printing a $1 bill costs the same as printing a $100 bill. Thus, for marginal private cost (and hence marginal private benefit) to equal marginal social cost, the nominal interest rate must be 0 percent. This, after Milton Friedman’s explanation, is now commonly known as Friedman’s rule. Assuming the real interest rate is positive, this means that the optimal inflation rate is negative.

When economists talk about the cost of inflation, they often frame the problem in this way. They are related to the inflation tax. Higher inflation increases nominal interest rates. This increases the cost of holding money. The higher cost of holding money means that people hold less money. It is expensive.

However, most estimates of these costs are quite small. However, inflation is rather unpopular.

To reconcile these observations, it should be noted that the structure of the inflation tax actually underestimates the costs associated with inflation. These expenses are only part of the story. To understand the whole story, we need to think about the role of these relative price effects and information.

First, relative price effects lead to a signal extraction problem. Even if monetary policy is known to have been expansionary, there may be uncertainty about the extent to which this expansion is permanent or temporary. In addition, it can be difficult to determine whether changes in relative prices reflect changes in supply and demand that would occur independently of monetary policy, or whether these changes are due to monetary expansion. This reduces the information content evident in relative prices.

There are several reasons why this might be expensive. If monetary expansion causes product prices to change faster than resource prices (or vice versa), this can give firms false signals about the profitability of certain actions. This increases the likelihood that firms will make mistakes in allocating resources.

Second, there’s something that’s late Steve Horwitz so-called “expenses for overcoming difficulties”. The difficulty in identifying true relative price effects versus policy effects can lead firms to divert resources to monitoring policy and making decisions based on expectations of future policy action. Thus, entrepreneurs must have knowledge of their particular production process, and perhaps some knowledge of economic theory as well. Additional expenses for accounting, financial managers and economists may be necessary for a firm seeking to avoid the costs associated with inflation.

Another form of cost recovery arises in contracting. Whether these contracts are between two firms or between firms and their employees, the negotiations will reflect expectations of future inflation. If the expectations are different, this may lead to a change in the duration or complexity of the contract.

Finally, the cost of inflation also includes the costs of the political response to inflation. Like the late Axel Leijonhufvud argued,

If a [policymakers] err on the side of inflation, of course, there will be widespread complaints about rising prices, but this vague message is completely drowned in the growing babble specific requirements and specific proposals from identifiable interest groups – offset to meregulate hiscontrol prices x and tax “excess profits” y, etc.

Sounds familiar?

When all these considerations are taken into account, it is easy to see why inflation can be quite costly. Although inflation is often referred to as a macroeconomic topic, it is clear that a solid understanding of price theory is needed to calculate all the costs associated with inflation. Something to keep in mind the next time someone calls for higher inflation.

Joshua R. Hendrickson


Joshua R. Hendrickson is an associate professor of economics at the University of Mississippi. His research interests include monetary theory, history and politics. He has published articles in leading academic journals, including the Journal of Money, Credit and Banking, Journal of Economic Behavior & Organization, Journal of Macroeconomics, Economic Inquiry and Southern Economic Journal.

Hendrickson received his Ph.D. in economics from Wayne State University. He received his bachelor’s and master’s degrees in economics from the University of Toledo.

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