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Source link: http://archive.mises.org/5730/did-phelps-really-explain-stagflation/

Did Phelps Really Explain Stagflation?

October 10, 2006 by

The Nobel committee credits Phelps for clarifying the relationship between inflation and unemployment. Indeed, he did made a contribution in this respect. What he did not do is what most economists credit him for doing: identifying the true causes behind the phenomenon of stagflation. Phelps could have made a great contribution to the economic profession by dismissing the entire framework of the supposed trade-off between inflation and unemployment (the Phillips Curve). Unfortunately he chose to stick to the bankrupt framework by making some amendments to it. Contrary to the accepted way of thinking, his amendments have not furthered our understanding of macroeconomic conditions such as stagflation. FULL ARTICLE


Timothy October 10, 2006 at 10:07 am

Very perceptive article, though there could be situations where short term unexpected increases in inflation could increase measured economic output (whether or not they could actually increase economic welfare in an objective sense is another question). If there are constraints on the wage rates which workers can be paid, such as minimum wage legislation or agreements negotiated by government protected unions, then an unanticipated increase in the price level could amerliorate the production reducing effects of them. In general, an increase in money supply would cause entrepreneurs to increase prices before Parliament and their trade union cohorts increased minimum wages, thus lowering effective minimum wages. Another case of one government intervention (wages legislation) leading to some positive benefits from other intervention (money supply growth) which, however, also has other larger, negative effects which lead to more government intervention ad infinitum.

Roger M October 10, 2006 at 10:20 am

I’m having trouble reconciling this article with “Chinese Growth: Real or Credit-Driven?” This one says credit expansion causes price increases, which is how I have always understood it. The China article says that the credit expansion has caused price reductions in consumer goods, though increases in the prices of goods for production. Can anyone help me here?

Stefan Karlsson October 10, 2006 at 11:18 am

Of course credit expansion will lead to a short term increase in growth. That’s why its called a boom. The initial receivers of money in the ABCT scenario are entrepreneurs who use it to capital investments. These investments will in the short-term mean a larger production capacity and thus higher short-term growth.

David Spellman October 10, 2006 at 1:06 pm

If the first receivers of money created out of nothing use it to build factories, then the economy grows. If the first receivers of the money are unemployed workers or welfare basket cases, then the economy contracts. It is unjust to create money either way, but the effect varies by who the criminal gift is bestowed upon.

Curt Howland October 10, 2006 at 1:49 pm

Quick Nobel Prize question: Other than Hayak, has there been a real Misian given the Nobel Prize for Economics for something actually Misian?

If this sounds convoluted, just look at this article. The Nobel Prize winner’s Nobel Prize winning contributions are shot down in flames. Are the Prize committee members really ignorant in the realm of economics, or is it an attachment to statism that blinds them to the negative repercussions of what they are rewarding?

Tim Swanson October 10, 2006 at 3:41 pm

Curt, regarding the Nobel Prize committee. While the decision is largely done behind the scenes, sometimes it has been based on political lines.

See: The Myrdal Mystery: The Gift That Keeps On Giving

And: What do prize committees maximize?

happyjuggler0 October 10, 2006 at 8:04 pm

Tyler Cohen at Marginal Revolution posted a list of things Phelps did, not just what was listed in this article.

Regardless of what one believes is the exact transmission method of inflation, Milton Friedman and Edmund Phelps had one thing in common. They both predicted 70′s stagflation before it happened, before there was even a word for it. This in marked contrast to the 99% of economists who were clueless at the time.

Knowing that inflation is everywhere and always a monetary phenomenon, and does not add to long run economic growth or to lower unemployment in the long run is the most important part of the battle.

As the economics profession was forced to regroup, the world hasn’t been the same since. Virtually no one is an (old) Keynesian now.

Alexander Villacampa October 11, 2006 at 1:07 am

Fantastic article! Kudos!

olmedo October 11, 2006 at 12:38 pm

the real thing tht needs to be examine here is weather GDP and its travelling companion “CPI deflator” can measure “growth” of the “real economy” at all.

for me they are all no more than statistical fallacies.

can “growth” really be measure in absolute terms??


David J. Heinrich October 11, 2006 at 12:48 pm


And you think that this was a surprise to Austrians at the time? No. In fact, Austrians predicted as much as well, and also have a correct understanding of what inflation is and it’s effects. Contrary to the Austrians, Chicagoeans like Irving Fischer predicted ever-lasting boom on the eve of the Great Depression, whereas Mises and Hayek had predicted a Depression. Fortunately, there was poetic justice and Fischer went bankrupt.

L.R. October 11, 2006 at 1:45 pm


In short, no.

According to the Advocates for Self-Government list (http://www.theadvocates.org/celebrities/), five Nobel laureates have been libertarians–four economists and a chemist (who believes in astrology…).

Of the economists–Hayek, Milton Friedman, James Buchanan and Vernon Smith–only Hayek can really be called Austrian (though even he wasn’t really “Misesian”–search his name on mises.org and you’ll find ample controversy on that account). Friedman has been fairly hostile to the Austrian school (though not nearly as hostile as they’ve been to him); Smith has spoken rather glowingly of Mises, but his work is too empirical to have much direct import to most Austrians.

Buchanan has also been rather apathetic, I think, though his early book “Cost and Choice” is very Austrian in its reasoning. And the Austrian (neo-Austrian? post-Austrian?) Peter Boettke is Deputy Director of his Center for Political Economy at George Mason.

Mark Anderson October 12, 2006 at 6:39 am

Thanks, Dr. Shostak for another very enlightening article.

Dr. Shostak wrote: “We have seen that according to PF, loose monetary policy can only grow the economy in the short term but not in the long term. In this sense, PF have accepted mainstream ideas that for a given level of prices, an increase in money supply increases the purchasing power of money, which in turn lifts the overall demand for goods and services. (To be more precise, PF are saying that the rate of increase in the money supply must be unexpected.) The increase in overall demand in turn triggers an increase in the production of goods and services — demand creates supply. In this sense money is an agent of economic growth.”

Well said, Dr. Shostak. Their argument runs contrary to J.B. Say, who taught us that it is through supply individuals are able to exercise demand. PF’s explanation actually runs contrary to the Austrian theory on the cycle. The problem down the road isn’t due to the fact that people start “expecting” inflation, it was the inflation itself which fueled malinvestment. PF’s idea is that inflation can work, so long as people are deceived. Just change around the CPI, and all is well?

Mark Anderson October 12, 2006 at 6:42 am

To the one who asked if there has been a Nobel Prize awarded to a real Misesian, other than Hayek, I just wanted to point out that Hayek wasn’t a Misesian. Hayek went over to the Chicago School, i.e., the Monetarist/Friedmanite branch of the socialists. You really think a real Misesian would be considered for a Nobel Prize?

Björn Lundahl October 12, 2006 at 3:38 pm

Recessions and The Great Depression were caused by Government Interventions!

In a purely free market (without Government intervention), the rate of interest is determined by people’s “willingness to save and invest” (which is called people’s time preferences) for future use, as compared to how much they are “willingly to consume now”. If people change their “willingness to save” (time preferences) and want to save more, the additional savings will cause the rate of interest to fall (increased supply of savings), and businesses will borrow and invest these additional savings. When the Central Bank (for example The Federal Reserve) increases the money supply and expands bank credit (which Central Banks does everywhere and all the time and always “out of thin air”), it initially lowers the rate of interest and thereby misleads businessmen to act in a manner as if true savings have increased, which in turn leads businessmen to invests those supposed savings in capital goods. New projects that were not profitable before, will now suddenly with this lower interest rate, be profitable. While this process is working, the economy is in an inflationary boom phase (expansion). Capital goods such as stocks, real estate etc, will be more demanded and invested in, and prices of those will rise faster and more intensely in relation to consumption goods. As these supposed savings have worked their way through the economy, prices of goods, services and wages have generally increased to a height which prices for them would have not reached without these supposed savings.

As mentioned, people’s “willingness to save and invest” have not changed (people’s time preferences have not changed) for it was only the Central Bank that increased, out of thin air, additional “savings”. When supposed savings have worked their way through the economy and are received, finally, in increased wages, people still spend their real wages in the same manner as before. They save/ consume in real terms and in same proportion to each other, as before mentioned increase in supposed savings. Because of this, a lack of savings will occur and the rate of interest will rise. Projects that businessmen have invested in and that seemed to be profitable when the rate of interest was lowered are now revealed to be unprofitable. All those investments are revealed to be malinvestments. Businessmen will stop investing in those projects and lay off workers. Prices of capital goods, real estate, stocks etc, will fall sharply and relatively to the fall in prices of consumer goods. The economy is in a depression phase. When those investments are liquidated, the economy is adjusted to people’s “willingness to save and invest” and to consume. The economic structure corresponds to the ratio which people want to save and consume. The economy is now healthy again.

Now then, in the 1920s the Federal Reserve, in the US, increased the money supply and bank credit, which in the 30s resulted in The Great Depression. The same story goes with Japan during the 1980s, which during the 90s, resulted in a depression (go to; http://en.wikipedia.org/wiki/Japanese_asset_price_bubble).
In Sweden we had banks lending out heavily during the late 80s, which also, led to a depression in the 90s.
All business cycles are caused by the same phenomenon. Economic crisis can occur because of other factors such as wars, boycotts, oil prices etc, but pure business cycles have in common the same cause.

I have tried, in a very few words and in a easy manner, to explain Ludwig von Mises business cycle theory, which is also called the Austrian theory of the business cycle. All faults are mine. Friedrich August von Hayek elaborated this theory and received in 1974 the Nobel Prize for this. Go to;

If you want to know more about this theory, go to;

Björn Lundahl
Göteborg Sweden

Roger M October 12, 2006 at 4:05 pm

Bjorn, Do you think the article “Chinese Growth: Real or Credit-Driven?” was wrong in saying that the Austrian theory predicted prices decreases for consumer goods?

It’s my understanding that a credit-induced expansion will cause investment in higher order goods because they are most sensitive to interest rates. That investment will increase employment and therefore demand for consumer goods. However, since no increase in consumer goods production has occurred, the increased demand will drive up consumer prices. Isn’t that standard Austrian?

We should also point out that even under a gold standard business cycles will still exist as long as fractional banking takes place.

Mark Anderson October 13, 2006 at 5:26 am

Roger, I think your understanding that malinvestment need be in higher order goods is a little off. Malinvestment, if that is the proper word, can be in any sector. Therefore, it might actually be better called malconsumption. As an example of one of the biggest beneficiaries of inflation: Government. Is the state a higher order good?

banker October 13, 2006 at 5:52 am

I think the point is that the people who receive the money first don’t purchase raw materials. The government usually doesn’t purchase oil, lumber, or iron ore. The government usually purchases things like airplanes, computer systems, buildings, etc. These are final stage goods. This is the same for those people and companies who take out loans to purchase plasma tvs and real estate.

adi October 13, 2006 at 6:17 am

I have serious doubts considering Austrian Business Cycle theory (ABCT); 1) Classification of goods into different orders (why not same good being in different categories depending on it’s use in different sectors of economy) 2) relation between interest rate and degree of roundaboutness of production processes 3) measurement of capital 4) role of expectations.

These all are important questions and I think that the ABCT is not able to give satisfactory answer to these. Of course mainstream theories are more wrong than Austrian ones (Real Business Cycles and all crap like that.

We should be aware of following refutations/discoveries by economists; 1) refutation of unambiguous measure of degree of roundaboutness by Knut Wicksell in Lectures on Political Economy 2) that degree of roundaboutness depends on interest rate by John Hicks in Capital and Value.

Does anyone know about so called Wicksellian effects in capital theory?

So in short you cannot say that the decrease of interest rate will result greater capital intensity.

Björn Lundahl October 13, 2006 at 6:51 am

Roger, I think that Austrian theory predicts that during the boom, credit expansion will cause prices for goods of the higher order to increase relatively to prices for consumer goods.

During recession/depression, prices for goods of the higher order will fall more sharply than consumer goods or if inflation is still sustained but to a lesser degree, prices for goods of the higher order will have less price increases than prices for consumer goods.

Without having any particular knowledge about China, I do believe that China is growing because of a freer market, increased savings/investments, hard work and so on. Credit expansion in China is occurring in spite of mentioned fundamental cause for economic growth. Sooner or later, credit expansion will only cause a recession/depression.

“We should also point out that even under a gold standard business cycles will still exist as long as fractional banking takes place”. Yes, I agree, this is very important! The great depression occurred during the gold standard, but its very cause was the fractional banking system.

Björn Lundahl
Göteborg, Sweden

banker October 13, 2006 at 7:18 am

“relation between interest rate and degree of roundaboutness of production processes “– this is a question

The answer:

For starters lets start with just a single company that sells widgets. It needs capital to buy the raw materials, equipment, real estate, and hire people to do the work of making widgets. Capital has a price (the interest rate the company pays). It takes time from when all the capital is spent producing the widgets until cash is received from the widgets being sold. When one considers the time value of money (more time = higher cost of capital) then a higher interest rate can restrict the ability of this company to produce widgets (decress supply of widgets).

Now consider multiple firms in a linear production process (for simplicity consider oil). One firm drills for the oil. Another ships it to refiners. Another company refines the oil into gasoline and then ships it to gas stations. Gas stations then sell it to consumers. In this example consumers are the driver of demand for oil via their consumption of oil. Capital is needed for each stage of the production process. The longer and more capital it takes to get oil from under the ground into the tank of my car the more expensive it will be for all the companies. The higher the interest rate the higher the cost of capital for these companies.

So in summary, the higher the interest rate the less time and capital a company(companies) has to turn raw material into revenue from selling consumer goods. Less time and capital means that goods which require higher numbers of refining processes are less profitable. This is how interest rates and the “round-aboutness” of production processes are related.

banker October 13, 2006 at 7:39 am

“3) measurement of capital 4) role of expectations.”–2 questions that can be knocked out in one answer

The answer:
The measurement of capital is a fluid concept, but only in the number of different ways one can use one’s savings. Capital (in a currency context) refers to the money available for investing. In the law demand and supply the time period to which one refers to can change the measurement of the quantity of capital. So whether you are referring to trying to find an investor for your pizza shop in one day or 1 year can make a difference on how much capital is available.

The two forms of investment are equity and debt investment (any where in a company’s capital structure, pick your poison). Assuming investors are risk averse (a very safe assumption) people make assumptions about the riskiness of the future cash flows promised by said financial security. The price is measured in “asked for returns” (%). Forecasts/expectations come into play because investors have to predict future cash flows and price accordingly (higher risk -> higher interest rate). Also one has to take into consideration the time value of money (risk free rate) into a company’s cost of capital. So the investor has to find something for his/her risk/return preferences; this is a guess because risk is an unknowable unknown.

Hence, changes in expectations can affect the relative value of securities -> change in risk/return relationships. The manipulation of interest rates by the Fed changes the risk/return relationship. This causes the business cycle.

This is a rough answer; I would be happy if someone expanded on this.

quasibill October 13, 2006 at 8:33 am


It seems to me that the relation between interest rate and roundaboutness has implications in vertical integration. Am I missing something?

For example, as long as there are gas stations willing to buy gas from the refiner (to turn around and sell to consumer), the refiner is can complete the loan cycle with that sale, decreasing the length of the loan to that particular firm. As such, there would seem to be a natural limit (seemingly based upon the average time preference in the given market) to the extent that vertical integration can remain profitable in the open market. Vertically segregated firms would have an advantage related to the shorter turnaround times for paying off loans, thereby (arguably) receiving lower risk premiums.

Is there something I’m missing here?

Roger M October 13, 2006 at 8:59 am

“I think that Austrian theory predicts that during the boom, credit expansion will cause prices for goods of the higher order to increase relatively to prices for consumer goods.”

Actually Robert Blumen, author of “Chinese Growth: Real or Credit-Driven?” on Oct 9, actually wrote this: “The rising costs at the for inputs at the high end of the structure in the face of falling prices for output due to overcapacity in the next stage is exactly what an Austrian economist would expect to occur toward the end of the cycle of a credit-driven boom.”

I think I misunderstood him. He wasn’t actually talking about consumer goods, but the output of higher order production and that seems to fit well with Austrian thinking.

In addition to fractional banking, we should keep in mind that productivity increases can mask the effects of monetary inflation. I think this happened in the 1920′s and the 1990′s. Huge productivity increases in both decades kept price inflation low while monetary inflation increased at high rates. In the 1990′s, the real prices of commodities declined for most of the decade because of productivity increases. When the productivity increases stopped due to slower investment, the effects of monetary inflation caught up with prices and prices of all commodities soared.

banker October 13, 2006 at 9:11 am

From my interpretation of your question, I think it would be better to consider from a different perspective. I don’t think interest rates have much of an effect on whether it is more profitable for companies to be vertically integrated or not.

Instead, this is more of a mergers and acquisition question. In this context, the comparison is between the volatility of an integrated company’s earnings and a portfolio of companies’ earnings. Volatility is a proxy for risk, which adds to the cost of capital for companies. Are there enough synergies between two companies that would warrant them combining into a single company? This is the main question with regards to integration.

Supply starts from the raw materials (lumber, oil, etc) from which the supply curve has a cascading effect from each point in the supply chain. Demand comes from the end good (chairs, gasoline, etc) and cascades in the opposite direction. At each point in the supply chain there is a “market” for intermediate goods (plywood, plastic, etc). I put quotations around the “market” word because this could either mean explicit transactions between two seperate firms or resource allocation decisions made by a manager in a vertically integrated firm. So interest rates have roughly the same effect.

Roger M October 13, 2006 at 9:26 am

Adi: “We should be aware of following refutations/discoveries by economists; 1) refutation of unambiguous measure of degree of roundaboutness by Knut Wicksell in Lectures on Political Economy 2) that degree of roundaboutness depends on interest rate by John Hicks in Capital and Value.”

Can you provide links to those refutation on the web? I’d like to read them.

I can see the logic of “roundaboutness”, though I think the term used today for the same concept is “product cycle”. A plastic water jug takes much less time to produce, the product cycle is much shorter, than the production cyle of an airliner. So it makes sense that the production $1 million worth of plastic jugs will take less time than the production of one airliner that costs $1 million. Since the jug producer can pay back the loan more quickly than the airliner producer, he’s less sensitive to interest rate changes.

adi October 13, 2006 at 9:46 am

Roger M;

For Hicks analysis about degree of roundaboutness you must read Capital and Value (or Capital and Time). I dont remember exactly what chapter(s).

For Wicksell’s analysis try;
Wicksell on capital

Paul Edwards October 13, 2006 at 11:11 am


“Roger, I think your understanding that malinvestment need be in higher order goods is a little off. Malinvestment, if that is the proper word, can be in any sector. Therefore, it might actually be better called malconsumption. As an example of one of the biggest beneficiaries of inflation: Government. Is the state a higher order good?”

It is only the malinvestment in higher orders of production induced by inflation that is pertinent to the ABCT. Increased consumption by the state or others due to credit expansion does not influence business cycles, as does the corresponding malinvestments in the higher orders of production.

Roger M October 13, 2006 at 12:12 pm

Paul:”Increased consumption by the state or others due to credit expansion does not influence business cycles…”

Wouldn’t the increased consumption cause price increases for consumers goods, which would then cause the Fed to raise interest rates and cut off the expansion?

Paul Edwards October 13, 2006 at 3:11 pm


“Wouldn’t the increased consumption cause price increases for consumers goods,”

I would think so.

” which would then cause the Fed to raise interest rates and cut off the expansion?”

Oh i see, giving rise to the business cycle? The business cycle hinges on malinvestments, not on consumer price inflation resulting in a FED/bank induced credit contraction.

The artificial lowering of interest rates during the expansion boom period encourages investment borrowing for areas which would otherwise not be borrowed for. This can give rise to a redistribution of resources from more urgently needed investments to others. It is the fact that normally unsustainable investments, given the present time-preferences of the market, are made because of the artificial expansion of credit and lower interest rates, that two things happen. Resources are simply wasted in unprofitable higher orders of production, and production in more urgently demanded lower orders of production is reduced.

When the threat of hyperinflation and loan defaults induces the FED/banks to contract, these malinvestments are revealed, they must be liquidated, and resources must be moved to more profitable endeavors. This is the bust, with business failures, and unemployment.

If credit expansion only affected retail demand, but DID NOT influence investment in higher order production, (an impossible scenario, I think) then you would have fluctuations in retail prices only, but no real ABCT boom bust situation. This is at least my take on the ABCT.

L.Baggiani MV=PQ October 16, 2006 at 12:56 pm

In my opinion, Shostak missed several major points in his analysis of Phelps’ work.
Shostak wrote that “PF have accepted mainstream ideas that for a given level of prices, an increase in money supply increases the purchasing power of money, which in turn lifts the overall demand for goods and services [...] the increase in overall demand in turn triggers an increase in the production of goods and services”, thus letting PF’s model seem to be working in a keynesian fashion.
But, in this case, Shostak has missed to explain the true working of the model, as exposed by PF, that the increase in money supply triggers an increase in prices which in turn lower real wages, allowing a higher level of production (rigidities or stickiness in wage fixing are subsumed) in the first round.

At the same time Shostak forgot Mises’s lesson: higher money supply involves lower interest rates, who in turn allow for an (artificial and temporary) boom in credit hence in production; Shostak himself has exposed this mechanism in “The Profet of the Great Depression”.
In both PF and Mises, this boom is an illusion (even though Mises has brought his analysis some farther to developing a complete Business Cycle Theory). Larry Sechrest in “Two Natural Rates: Friedman and the Austrian” shows that Monetarists and Austrians get the same conclusions, though the former focus on labour market and the latter on credit (Sechrest labels labour market as the “effect” and credit as the “cause” within a cycle unwinding).
Shostak also forgot that Monetarists fought Keynesians, weaving the flag of monetary policy’s inability to boost real growth, the same as Neoclassicals and Austrians: the stagflation model shows that lax monetary policy cannot bring real growth but only higher prices.

Moreover Shostak denies any role to inflationary expectations in affecting today’s prices, writing that “if [...] receivers of money now anticipate higher inflation in the future they may lower their present demand for money. Once they lower the demand for money and increase the amount of goods bought, only then [...] will the prices of goods start rising in line with expected increase in price inflation”.
But Shostak, in “The Profet of the Great Depression”, wrote that accelerating the pace of money supply growth “the purchasing power of money tends to fall by a much larger percentage than the rate of increase in money supply. Mises attributed this to increases in inflationary expectations [...] Inflationary expectations lead the suppliers of goods to ask for prices that are above what the holders of money can pay”, that is to say they will not await inventories running out before raising prices, but merely act in response of expectations. In a Monetarist view, this involves lowering real wages.

Concluding, Shostak seems to have ill-reported (or ill-understood) PF’s model, and located PF in a keynesian-like context which they actually used to fight, thence his critique cannot be righteously adressed; moreover he tried demolishing the model by the use of intellectual tools inconsistent to the Misesian thought that Shostak himself had previously exposed (a blunted knife to attack a non-existing enemy, then).
PF offered in turn an explanation of the economic path leading to stagflation, showed as the damage an expansionary monetary policy takes, even while trying to exploit the (supposed at least) Phillips curve (Shostak did not prove to have caught this point, which ultimately is PF model’s aim) that should rise cheers from any no-State-intervention supporters.
We can question whether Phillips and PF’s theories still hold in the present globalized context, but in those times they did. We should question how important a flaw it can be, to make no mention of the credit market mechanism, or whether PF’s results were implicit in the state of the art, but PF’s model says what happened (obscure to the most at the time) and its merits lie here.

Even though Austrian theory seems to better highlighting the first cause of economic development (while Monetarist focuses on an “intermediate” effect such as labour market’s development) those three master economists (Phelps, Friedman, and Mises) do not seem to disagree this much and prove to be consistent to own school’s teachings.

Alan Dunn October 19, 2006 at 8:42 am


Mr. Baggiani said:

“At the same time Shostak forgot Mises’s lesson: higher money supply involves lower interest rates, who in turn allow for an (artificial and temporary) boom in credit hence in production; Shostak himself has exposed this mechanism in “The Profet of the Great Depression”.

Wouldn’t this claim depend on how the interest rate is actually determined? Namely that, well in Australia anyway, the base interest rate is exogenously determined and maintained by the central bank through the manipulation of exchange settlement accounts of member banks held at the central bank.

Or in more direct terms, the interest rate is exogenously determined and the moneysupply is endogenously determined .

Thus, while the Central bank can somewhat determine the Money Stock it has little if any control over the “money supply”.

The government/ central banks activity are only one component of the money supply. Therefore, just because a component of the money supply increases it doesn’t always imply that the base or overnight short term fed rate changes.

Not a criticism just curious why people seem to assume that the money supply and money stock are one in the same; and that the interest rate is endogenously determined.


Baggiani October 19, 2006 at 4:55 pm


Mr Dunn is obviously right: money supply and money stock are not the same stuff. The distance between them depends on what measure of money supply we use though (M1, M2… ) and the farther we get, the less a Central Bank can control (but less is not “nil”).

I have mentioned money supply only, because I repeated the (maybe common, even not so much as mr Dunn showed) assumption that money supply is anyway linked to money stock, hence a Central Bank can more or less affect the former (unless a market strongly pushing in the opposite direction); this is commonly subsumed in stylizing an economy for modelling purposes at least (Mises did too).
At the same time, the base rate is not the rate used in a “secondary” market (between banks and borrowers), even though the two must obviously be linked (at least for banks’ balance-sheet’s sake); considerations about credit availability and risk perceived, for instance, affect credit market rates (mortgage interest rates do not vary only when base rate does, or am I wrong?).
On the same line, inflation itself does not necessarily move at the same “ratio” to different money supply definitions, never the less I find difficult to imagine falling prices together with increasing money supply.

Back to the model’s context, here a money supply increase and lowering interest rates necessarily come together. I pinpoint that, in this context, a Central Bank does not barely want to increase money supply (by affecting the stock), but wants to affect the “cycle”, wants to boost production, hence needs lowering interest rates; it can be done via open market operations, lowering the base rate, or reducing banks’ deposits required, by the Central Bank; this in effects involves more money in the economy. That is why, as I know it, I have always found theories which associate lowering interest rates to increasing money supply, while talking about Central Bank’s intervention, regardless to the difference mr Dunn has righteously stressed.

Alan Dunn October 19, 2006 at 9:39 pm

excellent summary Mr Baggiani.

“the base rate is not the rate used in a “secondary” market (between banks and borrowers), even though the two must obviously be linked (at least for banks’ balance-sheet’s sake); considerations about credit availability and risk perceived, for instance, affect credit market rates (mortgage interest rates do not vary only when base rate does, or am I wrong?).”

I think you are right in that the base rate probably only sets the absolute minimum rate. Where things get tricky is that in todays modern money economies; is private banks off-balance sheet activities.

I really don’t know much about the links between money supply growth and inflation (although I suspect there is a relaionship). This might suggest I’m not well versed in economics . But I think that the relationship is a lot more complex than many realise and probably can’t be explained adequately using the quantity theory of money and its partner in crime Say’s Law as a foundation.

My problem is possibly that inflation is not for me the central problem of economics. The problem for me is the existence of governments and central banks which exogenously determine prices, production, and ultimately employment.


L.Baggiani (MV=PQ) October 20, 2006 at 4:18 pm

Gentle Mr Dunn,

I sincerely used to believe in the quantity theory of money (I sometimes use MV=PQ as sort of signature), and I still believe it contains at least some power to easily analyse a context; but it surely lacks some major point that Mises (inter allios) has stressed: an increase in money supply sheds its effects into goods’ commodities’ and (mainly financial) assets’ prices.
In case you are asking (me) how prices “choose” in which class to grow the most (even to creating bubbles), I have no valid answer; I even doubt that someone has ever offered a valid answer yet: all that I have found on the subject tells about various forms or “irrationality” or “limited-information-set rationality”, “herd behaviour” and so on (not such much to draw a recognisable mechanism; then there is still room to win a Nobel).

Generally talking about monetary inflation, I think that some mechanisms can be accepted as able to explain at least part of the story, e.g. the monetarist “real balance effect”, the effect of lower interest rates into the “intertemporal consumption” choices, or Austrian consideration that more money to buy the same amount of production simply involves a decrease in money’s value itself. In my opinion, the greatest problem in analysing the relation between money supply and prices is quantitative instead of qualitative: we can agree that, through the three mechanisms I suggested and further ones, an increase in money supply involves an increase in prices, but we can hardly predict what prices will go how high.

As to your main concern, I can tell you that it is shared by even New-Keynesian economists (e.g. Galì suggests that authorities must let prices fall in case of particular productivity shocks, and rise in case of demand-side shocks, no matter how far), even though their aim is proving the State’s superiority over actual Markets.

In my opinion Pubblic Authorities cannot “exogenously determine” prices and production, but they can surely bias them from a “natural” free-market-path; in a sense, they create a sort of “excess” in the market which cannot but trigger an undesired reaction (in the PF model, for instance, the Central Bank tries to push production “above its maximum”, and it even succedes for a while, but this will be soon followed by another “excess” i.e. the return to the previous level of production together with a lower purchasing power of money besides other side effects due to an uneven rise in prices, which PF model does not investigate).
As Pubblic Authorities create a damage, other PA’s shall run into the economy to solve the problem; but any attempt is like an allopathic medicine (it cures an illness by letting another one come out), thence PA’s multiply like rabbits (the Mises-Critique content, if I am not wrong; I suppose you enjoy it).

See you.

Andrew Greene March 2, 2007 at 4:13 am

Taking a subjective view of money leads to a different conclusion about stagflation than Ned Phelps’, and even than Mr Shostak’s and the Austrian School’s. If, as Rothbard said, money is a medium and is not consumed, then increasing or decreasing its supply should have zero net effect on the underlying economy, other perversions aside.

To illustrate subjective value, compare money to a stock certificate. A company can issue new stock, thereby diluting an existing shareholder, but in doing so it will not erode the value of the company. In aggregate, that stays constant. What the new paper does, however, is take value from existing holders and transfer it to … well, usually to management (because management controls the cash paid in by the buyers of the new shares, but that is another story).

The point is that some individuals lose and some gain, but the company is worth the same. Mathematically, even a billion new shares would not alter its market value by one cent. You cannot determine value by counting shares. Lives and possessions are more than mathematics, as the Austrian School says, and value is personal. The question is not how much new stock is issued, but who is holding the old stock, who is issuing the new, to whom, and who is getting the cash? These are questions of individual control, therefore of property, and distorting property is the only way that issuing shares can destroy value.

So the macro-economy’s value does not change just because an issuer of currency turns on the presses. Yes, some people are being robbed to pay others, but the money supply could be infinite or infinitesimal with no change to total value—and this is the only logical result of Rothbard’s statement. The damage of stagflation is done not because the money supply is growing, or because of any other macro or averaged effect, but because something more fundamental is happening: printing (as the government practices it) is stealing. By undermining the property system, it wrecks the system of subjective pain and fulfillment that is the true motor of the economy. Just like a company issuing shares, a currency issuer who prints with abandon only does damage by robbing us, one at a time.

Andrew Greene, London

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