Commentator Jeff Ask an interesting question:
Thought experiment: What if the course of policy were such that everyone—all market participants: buyers and sellers, borrowers and lenders, producers and consumers—waked up one day and realized that money was worth exactly half of what they thought it was worth that day. Before?
How would this inflation be classified by those knowledgeable about dividing the effects of demand versus supply? 100% demand driven inflation? 50-50 demand/supply? 100% supply shock?
I imagine a well-meaning question should have a well-defined answer?
I’m going to tackle this with a detour, which I believe will highlight what’s wrong with most modern macros. I will begin with some thought experiments related to currency reform events, and then discuss how these examples relate to general demand shocks.
Developing countries that previously suffered from high inflation sometimes a Currency reform, such as exchanging 100 old pesos for 1 new peso in order to simplify arithmetic calculations for buyers. It’s sort of like a stock split, but in reverse. On the day these reforms are made, all nominal values immediately adjust to the same 100 to 1 ratio. Thus a 100 million (old) peso bond becomes a 1 million (new) peso bond. A 600 pesos/hour wage contract becomes 6 pesos/hour. Prices are also reduced by 99%. There is a perception that this price drop could be seen as a severe “inflation”, but almost no one sees it that way. Is it actually 99% deflation?
Two reasons can be given as to why this is not really inflation. First, inflation is measured as a fall in mean prices same currency. Under a currency reform, the new peso is a different currency from the old peso. (Europe’s adoption of the euro provides another example of this phenomenon.) Second, currency reform is in some sense “neutral,” like changing the length of a measuring stick, in that it does not affect any real quantity.
To see which reason is more necessary, I want to consider a thought experiment where only one of these two objections applies, and then consider how we would view that case. To simplify things, let’s take a look Inflationary Currency reform, say 1 old peso for 100 new ones. And let’s make one more adjustment-the new pesos will be identical to the old pesos- Exactly the same money. It’s hard to accomplish, but it’s just a thought experiment and we’re trying to work through what’s really going on here.
Usually, if you exchange 1 peso for 100 of the same peso, people will immediately turn around and do it over and over again. To prevent that outcome, assume that everyone lines up at a bank or government office at 12 noon on January 1st to exchange money, at which time each of their old pesos will be exchanged for a similar 100 rupees. No double dipping. As with other currency reforms, nominal contracts such as bonds and labor contracts are automatically adjusted by a ratio of 1 to 100. Thus like any other currency reform, there should be absolutely no real impact, we are just changing the length. Measuring stick.
Even in this case, I don’t think the public would see the phenomenon as a form of hyperinflation, because it has none of the real effects (output and wealth redistribution) usually associated with hyperinflation. The effects of this action are essentially the same as a conventional currency reform where one old peso is exchanged for 100 new and different pesos. And yet in a technical sense it’s really hyperinflation—since we’re measuring prices in the same currency.
The point of this review is to try to convince you that while one can cite two reasons why monetary reform is not generally seen as hyper-deflation or hyperinflation, only one reason is really essential. The essential reason is that monetary reforms are completely neutral, they have no real effect. Hence they are treated as non-events. After all, in a technical sense the thought experiment I gave you is really a 100-fold increase in the price level, which is really hyperinflation, because the type of currency hasn’t changed, just the amount of money. This is what I would call a Pure nominal shock.
This thought experiment helps us understand why most real world shocks are nominal There are real implications. In most cases, an official fiat does not automatically adjust all contracts to changes in the money supply or demand. This real-world nominal contract stickiness means that nominal shocks cause changes in real variables such as employment, output, and bankruptcy, effects that would not occur in a pure monetary reform without any nominal contract stickiness.
In my view, the best way to think about the business cycle is as a series of nominal (demand) shocks that would be completely neutral in a world of 100% contract flexibility, but would have important real effects due to their existence. of nominal contracts (plus firms are slow to adjust prices.) But that’s not how most economists view phenomena like inflation.
It is much more common for economists to describe inflation (a nominal process) as being caused by real shocks. Thus they can argue that a booming economy—that is, excessively rapid growth in GDP beyond the economy’s potential—causes inflation. Or too low unemployment causes inflation (Phillips Curve model.) To me this confuses cause and effect.
Of course in my view of causality, nominal and real variables are positively correlated with the business cycle. So does it really matter how we view causation?
Here’s why I believe it matters. A few months ago I think people were arguing that inflation wasn’t due to demand side factors, because “demand” hadn’t even returned to the pre-Covid trend line. I use fear quotes for demand, because they define demand not as nominal expenditure (which would be appropriate), but rather as real expenditure, which is highly inappropriate.
If the natural rate of output is 100% known in real time, the two approaches will give the same answer. But let’s say that the natural rate of output fluctuates in ways that are hard to predict. For example, suppose that Covid reduces the normal rate of production by 2% in 2022, reducing labor force growth (severely less immigration, people with longer Covid, fear of getting Covid, etc.) In that case, if RGDP were 1% below the pre-Covid trend line Go back, it would actually be 1% above the (depressed) natural rate of output. An economy that looked “depressed” would actually be overheating.
I want to pull my hair out when I see economists define “demand” as real output. This is an EC101 error. Real output is a quantity, it is just as much “supply” as demand. Actually it is neither demand nor supply Amount claim And Amount to supply. An appropriate way to measure aggregate demand is nominal expenditure-NGDP. And NGDP was well above trend in 2022. Any shortfall in RGDP was not due to weak demand, it was due to capacity constraints induced by the Covid shock.
The same mistake occurs when people argue that low unemployment (a real variable) causes inflation. Unemployment is a real variable, while demand is a nominal variable. It makes more sense to say that positive nominal shocks (higher money demand or lower supply) lead to lower unemployment due to sticky wages. And because the normal rate of unemployment is difficult to estimate, Phillips curve models of inflation are unreliable. You need to focus on NGDP.
The same mistake occurs when economists argue that low real interest rates are an easy money policy. Natural real interest rates move around a great deal. The Fed often finds itself in situations where it is raising rates but money is getting easier (1960s and 1970s) or it is cutting rates but money is getting tighter (1930s, 2008.) To confirm the stance of monetary policy, you have to look. . . You realize it. . . NGDP.
So while many economists will scoff at Jeff’s suggestion that an abrupt and neutral 2 for the price level 1 is a “demand shock,” because they see no change in actual demand, I believe Jeff is absolutely right. This is an unusual demand shock, because it appears to be a smooth equilibrium because everyone has 100% rational expectations and there is no negotiation of sticky prices, but it is still a 100% increase in the price level and a 100% increase in NGDP.
When making macros, don’t start by changing actual variables. Start with nominal shocks, such as changes in NGDP. Then figure out the real effects, which will be greater in economies with high wage stickiness (1930 and 2009) and smaller but still quite meaningful in economies with low wage stickiness (1921.) All economies have some stickiness except in unusual cases. A pure currency of reform.
A currency reform is like a lab experiment, showing us what nominal shocks would look like in a world without nominal contract stickiness. They help us understand why we see real effects in the real world. But the real effects (on RGDP or employment) are not the ultimate cause of the business cycle, they are an effect produced by nominal shocks in the world with wage/price stickiness.