A Monetary Policy Primer, Part 4: Stable Prices or Stable Spending?

deflation, inflation, price level, productivity, velocity of money
Noisy prices by George Selgin

NoisyPrices2Changes in the general level of prices are capable, as we've seen, of eliminating shortages or surpluses of money, by adding to or subtracting from the purchasing power of existing money holdings.  But because such changes place an extra burden on the price system, increasing the likelihood that individual prices will fail to accurately reflect the true scarcity of different goods and services at any moment, the less they have to be relied upon, the better.  A better alternative, if only it can somehow be achieved, or at least approximated, is a monetary system that adjusts the stock of money in response to changes in the demand for money balances, thereby reducing the need for changes in the general level of prices.

Please note that saying this is not saying that we need to have a centrally-planned money supply, let alone one that's managed by a committee that's unconstrained by any explicit rules or commitments.  Whether such a committee would in fact come closer to the ideal I'm defending than some alternative arrangement is a crucial question we must come to later on.  For now I will merely observe that, although it's true that unconstrained central monetary planners might manage the money stock according to some ideal, that's only so because there's nothing that such planners might not do.

The claim that an ideal monetary regime is one that reduces the extent to which changes in the general level of prices are required to keep the quantity of money supplied in agreement with the quantity demanded might be understood to imply that what's needed to avoid monetary troubles is a monetary system that avoids all changes to the general level of prices, or one that allows that level to change only at a steady and predictable rate.  We might trust a committee of central bankers to adopt such a policy.  But then again, we could also insist on it, by eliminating their discretionary powers in favor of having them abide by a strict stable price level (or inflation rate) mandate.

Monetary and Non-Monetary Causes of Price-Level Movements

But things aren't quite so simple.  For while changes in the general price level are often both unnecessary and undesirable, they aren't always so.  Whether they're desirable or not depends on the reason for the change.

This often overlooked point is best brought home with the help of the famous "equation of exchange," MV = Py.   Here, M is the money stock, V is its "velocity" of circulation, P is the price level, and y is the economy's real output of goods and services.  Since output is a flow, the equation necessarily refers to an interval of time.  Velocity can then be understood as representing how often a typical unit of money is traded for output during that interval.  If the interval is a year, then both Py and MV stand for the money value of output produced during that year or, alternatively, for that years' total spending.

From this equation, it's apparent that changes in the general price level may be due to any one of three underlying causes: a change in the money stock, a change in money's velocity, or a change in real output.

Once upon a time, economists (or some of them, at least) distinguished between changes in the price level made necessary by developments in the "goods" side of the economy, that is, by changes in real output that occur independently of changes in the flow of spending, and those made necessary by changes in that flow, that is, in either the stock of money or its velocity.   Deflation — a decline in the equilibrium price level — might, for example, be due to a decline in the stock of money, or in its velocity, either of which would mean less spending on output.  But it could also be due to a greater abundance of goods that, with spending unchanged, must command lower prices.  It turns out that, while the first sort of deflation is something to be regretted, and therefore something that an ideal monetary system should avoid, the second isn't.  What's more, attempts to avoid the second, supply-driven sort of deflation can actually end up doing harm.  The same goes for attempts to keep prices from rising when the underlying cause is, not increased spending, but reduced real output of goods and services.  In short, what a good monetary system ought to avoid is, not fluctuations in the general price level or inflation rate per se, but fluctuations in the level or growth rate of total spending.

Prices Adjust Readily to Changes in Costs

But what about those "sticky" prices?  Aren't they a reason to avoid any need for changes in the price level, and not just those changes made necessary by underlying changes in spending?  It turns out that they aren't, for a number of reasons.[1]

First of all, whether a price is "sticky" or not depends on why it has to adjust.  When, for example, there's a general decline in spending, sellers have all sorts of reasons to resist lowering their prices.  If the decline might be temporary, sellers would be wise to wait and see before incurring price-adjustment costs.  Also, sellers will generally not profit by lowering their prices until their own costs have also been lowered, creating what Leland Yeager calls a "who goes first" problem.  Because the costs that must themselves adjust downwards in order for sellers to have a strong motive to follow suit include very sticky labor costs, the general price level may take a long time "groping" its way (another Yeager expression) to its new, equilibrium level.  In the meantime, goods and services, being overpriced, go unsold.

When downward pressure on prices comes from an increase in the supply of goods, and especially when the increase reflects productivity gains, the situation is utterly different.  For gains in productivity are another name for falling unit costs of production; and for competing sellers to reduce their products' prices in response to reduced costs is relatively easy.  It is, indeed, something of a no-brainer, because it promises to bring a greater market share, with no loss in per-unit profits.  Heck, companies devote all sorts of effort to being able to lower their costs precisely so that they can take advantage of such opportunities to profitably lower their prices.  By the same token, there is little reason for sellers to resist raising prices in response to adverse supply shocks. The widespread practice of "mark-up pricing" supplies ample proof of these claims.  Macroeconomic theories and models (and there are plenty of them, alas) that simply assign a certain "stickiness" parameter to prices, without allowing for the possibility that they respond more readily to some underlying changes than to others, lead policymakers astray by overlooking this important fact.

A Changing Price Level May be Less "Noisy" Than a Constant One

Because prices tend to respond relatively quickly to productivity gains and setbacks, there's little to be gained by employing monetary policy to prevent their movements related to such gains or setbacks.  On the contrary: there's much to lose, because productivity gains and losses tend to be uneven across firms and industries, making any resulting change to the general price level a mere average of quite different changes to different equilibrium prices.  Economists' tendency — and it hard to avoid — to conflate a "general" movement in prices, in the sense of a change in their average level, with a general movement in the across-the-board sense, is in this regard a source of great mischief.  A policy aimed at avoiding what is merely a change in the average, stemming from productivity innovations, increases instead of reducing the overall burden of price adjustment, introducing that much more "noise" into the price system.

Nor is it the case that a general decline or increase in prices stemming from productivity gains or setbacks itself conveys a noisy signal.  On the contrary: if things are generally getting cheaper to produce, a falling price level conveys that fact of reality in the most straightforward manner possible.  Likewise, if productivity suffers — if there is a war or a harvest failure or OPEC-inspired restriction in oil output or some other calamity — what better way to let people know, and to encourage them to act economically, than by letting prices generally go up?  Would it really help matters if, instead of doing that, the monetary powers-that-be decided to shrink the money stock, and thereby MV, for the sake of keeping the price level constant?  Yet that is what a policy of strict price-level stability would require.

Reflection on such scenarios ought to be enough to make even the most die-hard champion of price-level or inflation targeting reconsider.  But in case it isn't, allow me to take still another tack, by observing that, when policymakers speak of stabilizing the price level or the rate of inflation, they mean stabilizing some measure of the level of output prices, such as the Consumer Price Index, or the GDP deflator, or the current Fed favorite, the PCE ("Personal Consumption Expenditure") price-index.  So long as changes in total spending ("aggregate demand") are the only source of changes in the overall level of prices,  those changes will tend to affect input as well as output prices, so policies that stabilize output prices will also tend to stabilize input prices.   General changes in productivity, in contrast, necessarily imply changes in the relation of input to output prices: general productivity gains (meaning gains in numerous industries that outweigh setbacks in others) mean that output prices must decline relative to input prices; while general productivity setbacks mean that output prices must increase relative to input prices.  In such cases, to stabilize output prices is to destabilize input prices, and vice versa.

So, which?  Appeal to menu costs supplies a ready answer: if a burden of price adjustment there must be, let the burden fall on the least sticky prices.  Since "input" prices include wages and salaries, that alone makes a policy that would impose the burden on them a poor choice, and a dangerous one at that.  As we've seen, it means adding insult to injury during productivity setbacks, when wage earners would have to take cuts (or settle for smaller or less frequent raises).  It also increases the risk of productivity gains being associated with asset-price bubbles, because those gains will inspire corresponding boosts to aggregate demand which, in the presence of sticky input prices, can cause profits to swell temporarily.  Unless the temporary nature of the extraordinary profits is recognized, asset prices will be bid up, but only for as long as it takes for costs to clamber their way upwards in response to the overall increase in spending.

What About Debtor-Creditor Transfers?

But if the price level is allowed to vary, and to vary unexpectedly, doesn't that mean that the terms of fixed-interest rate contracts will be distorted, with creditors gaining at debtors expense when prices decline, and the opposite happening when they rise?

Usually it does; but, when price-level movements reflect underlying changes in productivity, it doesn't.  That's because productivity changes tend to be associated with like changes in  "neutral" or "full information" interest rates.  Suppose that, with each of us anticipating a real return on capital of four percent, and zero inflation, I'd happily lend you, and you'd happily borrow, $1000 at four percent interest.  The anticipated real interest rate is of course also four percent.  Now suppose that productivity rises unexpectedly, raising the actual real return on capital by two percentage points, to six percent rather than four percent.  In that case, other things equal, were I able to go back and renegotiate the contract, I'd want to earn a real rate of six percent, to reflect the higher opportunity cost of lending.  You, on the other hand, can also employ your borrowings more productively, or are otherwise going to be able (as one of the beneficiaries of the all-around gain in productivity) to bear a greater real interest-rate burden, other things equal, and so should be willing to pay the higher rate.

Of course, we can't go back in time and renegotiate the loan.  So what's the next best thing?  It is to let the productivity gains be reflected in proportionately lower output prices — that is, in a two percent decline in the the price level over the course of the loan period — and thus in an increase, of two percentage points, in the real interest rate corresponding to the four percent nominal rate we negotiated.

The same reasoning applies, mutatis mutandis, to the case of unexpected, adverse changes in productivity.  Only the argument for letting the price level change in this case, so that an unexpected increase in prices itself compensates for the unexpected decline in productivity, is even more compelling.  Why is that?  Because, as we've seen, to keep the price level from rising when productivity declines, the authorities would have to shrink the flow of spending.  Ask yourself whether doing that will make life easier or harder for debtors with fixed nominal debt contracts, and you'll see my point.

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[1] What follows is a brief summary of arguments I develop at greater length in my 1997 IEA pamphlet, Less Than Zero.  In that pamphlet I specifically make the case for a rate of deflation equal to an economies (varying) rate of total factor productivity growth.  But the arguments may just as well be read as supplying grounds for preferring a varying yet generally positive inflation rate to a constant rate.

  • Jule Herbert

    Change"their" to "there" in the paragraph where you use "heck." (It's in the parenthetical phrase.)

    • George Selgin

      Thanks, Jule. The change has been made. Now I just have to worry about Paul Krugman calling it another example of Cato's "Orwellian" practices.

  • Andrew_FL

    Another good post! Looking forward to the part on "The Supply of Money"

    I've seen LK bring up mark-up pricing quite often, he seems to think it's a stake through the heart of Price Theory, though I'm not sure I get why he thinks that.

  • I am sure that those guys who overproduced, creating inflation, are soothed by George's calm assurance that the deflation they are experiencing isn't bad. Lol.

    I also, thought this is a tiny bit off the subject, would wonder what control of the money supply would be needed if we have blockchain? Blockchain, of course, is the labeling of all digital currency, in order to track it from cradle to grave. The money that is.

    So, so, so, sorry, can't help my self, I also have another question regarding blockchain. Once digital currency is id'd, wouldn't the bankers want digital money that is turned into physical money id'd as well? In other words, keeping track of physical money would require an electronic transaction for you to lend your son money, or put 5 bucks into a slot machine at a casino, or go to an R rated movie. Someone would know your every move.

    And what about the money supply with blockchain? So many questions so little time.

    And George, you said: "Of course, we can't go back in time and renegotiate the loan. So what's
    the next best thing? It is to let the productivity gains be reflected
    in proportionately lower output prices — that is, in a two percent
    decline in the the price level over the course of the loan period — and
    thus in an increase, of two percentage points, in the real interest rate
    corresponding to the four percent nominal rate we negotiated."

    Well, people had mortgages. The new houses were a lot cheaper than their house after the crash. So they mailed in the keys and failed to pay the mortgage. So, the bankers never got the opportunity to gain in the real interest rate because people walked away. But don't worry, the govenrment bailed out the banks, who also got the houses back.

    • Andrew_FL

      "I am sure that those guys who overproduced, creating inflation, are
      soothed by George's calm assurance that the deflation they are
      experiencing isn't bad. Lol."

      You didn't understand the point he was making.

      But even so, the group you are fixating on has no special claim on our attention or concern.

      • George Selgin

        In any case, "overproducing" makes prices decline, not rise!

      • Oh you mean US manufacturers? I didn't think central banks cared much for the real economy, Andrew!

  • gchakko

    It seems to me that people have a pre-ordained affinity for enjoyable confusion of concepts. Production is the basis of all economics. A sleeping man has no economic value as he produces zero output. Who sets the price, be it over- or less production, the consumer or the producer, ultimately the consumer, if he had enough or less of it. We are told the economy collapses or improves if production stops or is slowed. The price is too high, I don’t produce, because the consumer cannot take it, or I produce less if the demand is high keeping the price up, that’s judged as economic growth, a bit trivialised of course for day-to-day life.

    We are here on a merry-go-round. We all know that if the need is established, the supply is assured as corresponding production is there. When bottle necks emerge, as is the case of spot oil-market, the futures’ guys get in and manipulate prices. So, where do we start, the basic human need. The classical concepts need be binned, be it macro- or micro-economics, because we need to get in grips with the complexities of international trade that affect national economics, which is what the WTO or Doha rounds are about in our evolving Global Village. Farmer thinking psychology is still the backbone of common sense economic planning, because it is based on the belly and rain gods have
    to give their O.K (random variables) !.

    George Chakko, Vienna, Austria 17/05/2016 02:36 am

  • George, at this point and specific to the US, what is blocking full implementation of Hayek's Denationalisation from being realized? Specifically, 1) acceptance of all FX for goods, services etc. (is there a US law, exchange controls, preventing a merchant from accepting Yen, for example) and 2) private issue and acceptance of non-FR deposits and notes. When Hayek wrote about this in the 1970's I could see technology potentially being a problem, but today can hardly see where that would pose much of an obstacle. If a merchant can now accept Bitcoin, why could they not accept Yen or private issue notes?

  • I like the way George Reisman analyzes what happens in an economy with a fixed stock of money.
    Total spending can't increase if the money stock is fixed. If production increases prices must fall enough to accommodate the fixed stock of money available. With a fixed stock of money, NGDP would always have the same dollar amount and equal the stock of money available.

    I don’t think productivity increases will reduce average prices. With a fixed money stock, the savings from cheaper goods due to increased productivity will likely be spent on other goods and cause their prices to rise in proportion. That’s what happened in the 1920s before the Great D. when productivity rose dramatically but prices didn't.

    Again it’s not likely that “a harvest failure or OPEC-inspired restriction in oil output or some other calamity” would cause an increase in average prices because people would refrain from spending on some items in order to pay the higher costs of food or gasoline.

    A productivity increase would boost long run AS first. Prices would fall and GDP increase along the existing AD curve. That is textbook AD/AS analysis anyway. Next, larger income would shift the AD to the right to keep the price level the same.

    Shouldn’t banks be forced to keep a reserve that would allow them to respond to shocks just as they prepare for seasonal changes instead of the central bank doing it for them?