Misconceptions concerning inflation, Pt. II

Posted: February 4, 2012 by alephnaughty in Economics, Education
Tags: ,

Misconception #4: Inflation is the very same thing as printing money. Define inflation however you like–be my guest. Just note that if inflation is defined to be the printing of money, then the dominant theory of inflation, the quantity theory of money (QTM), becomes a tautology. The QTM says that x% money growth, in the long run, causes x% inflation. If inflation is the very same thing as printing money, then the QTM says that inflation leads to inflation in the long run. No shit. Let’s call rises in the price level ‘schminflation’, then, so we can carry on.

Misconception #5: Inflation causes bubbles, which cause busts. I should begin by observing that no one has a definition of “bubble” that satisfies anyone else. Note that just as the US housing bubble was supposedly developing, home prices were appreciating in many other countries, too. While US prices eventually came crashing down, prices in many other countries (e.g., Canada) have kept on rising. Have these countries figured out ways to keep their bubbles from bursting, or should we conclude that the diagnosis of bubbles ought to be left to Captain Hindsight? Prices go up, then they go down, then up, then down, … What insight is gained when we conclude that some one upturn followed by a downturn was a bubble, when no one can systematically identify bubbles ex ante?

In any event, below is the inflation rate during the 2000s:

And here is the Case-Shiller home price index during that same period:

Which came first, the housing bubble or the uptick in inflation? And which was first to reverse course? As for bubbles causing busts, note that the housing market began to fall apart long before the broader economy followed suit. Indeed, the collapse in the housing market didn’t even accelerate once the economy went into the tank. By contrast, inflation lingered at 2.0-2.5% per year before plunging in concert with the broader economy. A prescient paper by Ben Bernanke (with a coauthor) contends that the responsibility of monetary policy is not to identify bubbles in order to burst them, but rather to keep the broader economy stable as it absorbs the shock. The economy didn’t tank because the housing bubble burst; it collapsed because the Fed failed to keep AD on target. Had the Fed been aggressive enough in its response, the housing bubble would’ve ended with a whimper, not a bang. And it wouldn’t make a difference whether we thought the movement in home prices was a bubble or not. Inflation would seem, correctly, to have nothing to do with any of it.

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