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Scott Sumner Has Got Me all Confused

To be specific, he confuses me by his response to Ezra Klein's column quoting former FRB vice chairman Donald Kohn's opinion that “It’s difficult, if not impossible, to create persistent inflation without demand exceeding potential supply over an extended period” along with Lawrence Summers' view that "inflation is mostly driven by demand, and when you increase demand, you increase inflation. And if you don’t increase demand, you don’t increase inflation. But if you’ve solved demand, you’ve solved your problem.” To the question implicit in such remarks, regarding why anyone would expect the Fed to succeed in raising the current rate of inflation despite being incapable of increasing the current growth rate of aggregate demand, Scott's response is "Um, maybe because the Fed promised a more expansionary policy in the future?"

I realize that Scott wants his readers to imagine Kohn and Summers, upon hearing this reply, smacking their lower palms against their foreheads while saying "Dope!" But at the risk of appearing to be a dope myself, I confess that I believe that the statements by Kohn and Summers make perfect sense, whereas Sumner's rhetorical response does not.

It doesn't make sense, first of all, because, assuming a non-declining AS schedule, an increase in the rate at which prices increase that is not accompanied by a corresponding increase in aggregate spending must be accompanied by ever-declining sales and ever-worsening unemployment, and is for that reason unlikely to persist. So it would seem to be true after all that a persistent increase in the rate of inflation requires a persistent increase in the growth rate of aggregate demand relative to that of aggregate supply.

Of course I don't doubt for a moment that Scott understands this last point perfectly well. Unless I'm mistaken, what bothers him about the opinions expressed by Kohn and Summers is their implicit failure to appreciate the possibility that, when it raises its announced inflation target, the Fed also increases the expected rate of inflation, and with it the velocity of money. Consequently the Fed is able to boost aggregate demand and to combat recession without resorting solely to the usual, more direct but less reliable means of more aggressive monetary expansion, and its higher announced inflation target becomes in this respect at least partly self-fulfilling.

But even this more sophisticated objection to Kohn and Summers, understood (as I understand it) to imply that those experts have overlooked a potentially effective means for combating recession, seems wrong to me. True, if prospective buyers expect prices to increase, that's a reason for them to spend more now. But if prospective sellers expect consumers to spend more, that is a reason for them to start raising prices now. So while a higher announced inflation target might be self-fulfilling, there's no reason to suppose that by announcing such a target the Fed can achieve anything other than a higher rate of inflation.

Inflation expectations, in other words, inform the positions and rate of change of both demand and supply schedules–as should be especially obvious to anyone familiar with Wicksteed's famous exposition in which the latter schedules are nothing other than flipped-over portions of total ("communal") demand schedules. Changes in inflation expectations will, in still other words, tend to affect in the same manner the decisions of both buyers and sellers. Consequently, if sellers' expectations have been excessively rosy, so that their pricing decisions have resulted in disappointing sales, there's no reason to suppose that an announced increase in the inflation target won't cause them to become rosier still, ceteris paribus. Expectations are a double-edged sword that policy tends to sharpen on both sides, or not at all.

None of this contradicts the view, which I share with market monetarists, that an increase in aggregate demand that is not merely the result of an increase in the expected rate of inflation can be effective in reducing unemployment. For in that case, and again assuming that sellers' expectations have been excessively rosy, the increase serves, not to boost those expectations further, but to bring reality closer to them. To my way of thinking this difference between a policy that works by fulfilling established demand expectations that have been overly-optimistic, and one that seeks to boost demand by raising the expected rate of inflation, is absolutely crucial. If an economy is depressed because its rate of NGDP growth falls short of sellers' expectations, then surely the best way to close the gap is by raising the actual rate of NGDP growth only, while either leaving NGDP growth and inflation expectations alone or, were it possible to do so, lowering those expectations. I'm not saying that doing this is easy, by means of monetary expansion or otherwise. But it is nonetheless what needs to be achieved, and it is unlikely to be achieved by raising the Fed's inflation target.

It seems to me that monetary economists who overlook this obvious truth risk adding to rather than subtracting from our current monetary troubles. Maybe Scott isn't among them; maybe I've misunderstood him. Or maybe my own reasoning is all wrong. Like I said, I'm confused. But whatever the reason for my confusion I hope that Scott, or someone, will help me out of it.

Addendum (July 24): As the argument of this post is not the easiest to get across, I hope I may be pardoned for adding, by way of clarification, the observation that believers in NGDP targeting who also endorse raising the target (and thus the expected) rate of inflation as a means to end recession appear to subscribe to view, which I think badly mistaken, that, if economic recovery can be encouraged by providing for adequate (but not inflation-enhancing) NGDP growth, then it can be encouraged still further by promising a rate of NGDP growth such as would serve to actually increase the equilibrium inflation rate.

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