by Dirk Ehnts
A new ‘authoritative’ IMF working paper named On Price Stability and Welfare has just been published. I want to discuss the theory behind that paper. And I want to discuss also whether the assumptions used by the authors are acceptable for the current times.
Here is the main driver of the model (the other one is the menu cost channel):
Let me summarize very briefly why some inflation could be a good idea for some countries right now. In Europe, some countries have been net importers in the past, running up significant foreign debt. In order to repay that debt, they have to turn into net exporters. They can achieve that by pushing their own price level down (this is what austerity is meant to achieve) or by inducing their trade partner to inflate their respective economies. In this context, a higher inflation rate for, say, Germany could help adjustment.
In the US, the case of higher inflation might be based on the idea that indebted households face high real burdens of debt which should be lowered. One way of lowering these debt burdens is a higher than normal inflation rate. More consumption might be the result of this policy, leading to higher GDP growth. Mr Blanchard of the IMF suggested higher inflation rates – or better, higher nominal interest rates – in February 2010, as the WSJ reported:
In a new paper with two other IMF economists, Giovanni Dell’Ariccia and Paolo Mauro, Mr. Blanchard says policy makers need to consider radically different approaches to deal with major banking crises, pandemics or terrorist attacks. In particular, the IMF paper suggests shooting for a higher-level inflation in “normal time in order to increase the room for monetary policy to react to such shocks.” Central banks may want to target 4% inflation, rather than the 2% target that most central banks now try to achieve, the IMF paper says.
However that may be, the discussion of inflation without looking at either debt stocks or the international situation seems to me to be without merit. The opportunity cost channel argument is not convincing at all. A first indicator is the following question: would you reduce your cash holdings when the inflation rates goes up from 2 to 4 (or even 6%)? Would you? Let’s look at the data from the US, more specifically, let us look at the velocity of the M1 money stock and inflation:
The idea that if inflation rises people economize on their use of currency by spending the funds faster does seem to be evident from a quick look at the data. M1 has been chosen because it seems to be the proper measure. FRED writes:
M1 includes funds that are readily accessible for spending. M1 consists of: (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) traveler’s checks of nonbank issuers; (3) demand deposits; and (4) other checkable deposits (OCDs), which consist primarily of negotiable order of withdrawal (NOW) accounts at depository institutions and credit union share draft accounts. Seasonally adjusted M1 is calculated by summing currency, traveler’s checks, demand deposits, and OCDs, each seasonally adjusted separately.
There is another way to look at the theory of the Opportunity Cost Channel. The currency component of M1 stood at $1,053.3 bn. by the end of July 2012. Total financial assets of households and non-profit organizations by the end of Q2 was $52,524 bn. Cash then is only 2% of total wealth, and then the author would like us to believe that in order not to lose a fraction of 2% of total wealth the whole economy is clogged? And if menu pricing is another burden, which is the costs of changing the prices on the menu (more often), then a significant welfare loss would arise? And next to those two theories, there is nothing else in the paper about either the international problems of trade imbalances or the domestic problems of real debt burdens. That means, inflation has only costs and no benefits. What this means for results should be clear to everybody.
Adding more doubts to the validity of the results, let me point out that the model is a simulation that is using calibrated parameters. Those parameters are found by looking at past data. This might be a good idea during ‘boring’ times, where the economy does not change its behavior much. However, in the middle of a crisis it is not useful to use the past as an indicator to the present. Using parameters for money demand based on Lucas (2000) using data from 1900-1994 is a bit optimistic. Even the mainstream economists understand that something had changed in the way economy’s worked, which they called the Great Moderation. It was actually the Great Moderation before the storm, which they never saw coming. (Heterodox economists have called the phenomenom ‘Financialization’ and were able to predict problems better than the mainstream, as this paper by Palley (2007) shows.)
Notwithstanding the doubts about the validity of the paper’s results, the study got picked up by German newspapers the Handelsblatt, the ZEIT, and the Süddeutsche. All three do not question the research and present the result that higher inflation leads to a net welfare loss as a fact. They do not lose one syllable on the question of why.
About the Author
Dr. Dirk Ehnts is a research assistant at the Carl-von-Ossietzky University of Oldenburg (Germany). His focus is on economic integration and economic geography, covering trade, macro and development. He is working at the chair for international economics since 2006 and has recently co-authored a book on Innovation and International Economic Relations (in German). Ehnts has written at his own blog since 2007: Econblog 101. Curriculum Vitae.