Inflation/Deflation Expansion/Contraction and Price-Rise/Fall

Economics
1

I’m re-posting something I posted on another forum…

The term “inflation” is used to mean two things: a rise in prices and a rise in the quantity of money. One can try to use it to always mean one or the other, but one still needs a term to use when talking to others (it is unfortunate that there is no other word to describe “price-rise”). Anyhow, that is about convincing others. Before that, one has to form one’s own conceptualization. I think of it as follows:

Prices tend to rise when there is an expansion of the money supply. This is an abstract form of the so-called “Quantity theory of money” (Aside: I think this is the level of abstraction that is valid, while trying to get more more detailed, with P x Q = M x V, is potentially misleading.) At that level of abstraction, the quantity theory of money is a restatement of the ordinary Theory of Demand: when there is more of something, its price declines. When there is more of money, it’s “price” – in terms of other goods and services – declines… and the price of other goods and services (as expressed in money-- rises)

There are two important additions to this:

  1. Money itself has many close substitutes. So, the laws of substitution also apply. If the supply of a certain type of banana stays constant but the supply of another close substitute suddenly rises, it can make the price of the former fall, since some demand is satisfied by using the plentiful (and, now, cheaper) variety. Economists debate about whether money is best described as M1, or M2, or MZM, or M3. Actually, there is a whole continuum of substitutes. We might have to choose one or two of those if we’re to compile a metric; but, that metric will only hold as long as the mix of substitution stays within a narrow range.

The payoff of this point is this: we live in an economy where credit is a large part of transactions. Some transactions – like home purchases (perhaps autos too)-- have more credit flowing from the buyer to the seller than they have “real” cash. Given the system we have in place, this credit is not necessarily someone else’s cash being channeled to the seller. It can be manufactured money (i.e. expansion). In our money day economy, the largest expansion of money is driven by the expansion of credit, not the printing of bills. We’ve had a long-time expansion of bills. In addition, what we had in the recent past was a particular expansion of credit.

  1. When money is expanded, the new money hits some particular person first. Someone gets the “free-gift”. So, this person’s ability to spend goes up while that of everyone else remains the same. So, the price-rise impact will be felt in areas where this person spends money. Of course, such expansion happens across thousands of people, so it’s an easy assumption to think that such expansion happens somewhat evenly across the population. However, this is mostly not true. Credit expansions are often targeted. Sometimes it could be targeted at a geographical area, sometimes at an industry, etc. The less-targeted areas will then not see an impact for a while. The knock-on effect of such targeting is that impacts relative market values. Instead of everything rising in price, homes might rise in price much more than other assets. This, in turn, changes the valuation calculus and increases the relative demands between goods. In the case of homes, it made more people think of homes as an investment, which was false. This brought forth more relative demand for housing. It is very difficult to parse out the various motivations of buyers in the aggregate; so, these things have a temporary self-fulfilling effect while they look just like a real increase in demand. They are made worse by charlatans who pile on seeing that they can ride a bubble for a year or two.

As time passes, it becomes apparent that the change in relative demand was a fiction. The change was in nominal (money/credit) terms, but not in real value. People really do not value housing so much more than everything else. Since the focus of monetary expansion has been an asset market, where valuations are based on future expectations (housing, stock-market, etc.) the change in expectations can cause a crash. [e.g. If I think gold will go to $2000 in 5 years, it is worth a certain amount to me; if I think it will go to $2000 in ten years, its current value to me crashes.] Since this asset has been financed by credit, the buyer’s ability to repay comes into question. Thus starts the fear phase and the default phase. This is a phase where credit contracts as a whole lot of credit is simply written off, while banks are more wary of giving new credit, and people are more wary of taking on new credit.

So, for a little while we’ve been in a phase of contraction of credit that has counter-balanced the Fed’s creation of new money. In addition, in a phase like this, the demand for money rises (witness all the talk of money “sitting on the sidelines”). We’re somewhere in that contraction phase now.

2

As time passes, it becomes apparent that the change in relative demand was a fiction. The change was in nominal (money/credit) terms, but not in real value. People really do not value housing so much more than everything else. Since the focus of monetary expansion has been an asset market, where valuations are based on future expectations (housing, stock-market, etc.) the change in expectations can cause a crash. [e.g. If I think gold will go to $2000 in 5 years, it is worth a certain amount to me; if I think it will go to $2000 in ten years, its current value to me crashes.] Since this asset has been financed by credit, the buyer’s ability to repay comes into question. Thus starts the fear phase and the default phase. This is a phase where credit contracts as a whole lot of credit is simply written off, while banks are more wary of giving new credit, and people are more wary of taking on new credit.

To add something to this…

If the Fed engaged in a simple one-time expansion of credit, relative prices in the economy would be initially warped and then gradually come back into alignment as time passes and the new credit circulated through the economy. However, the Fed operates by setting a target interest rate, and when they set the target below what the market rate would be, they have to continuously pump new credit in order to maintain this rate. This continual flow of new credit serves to maintain the distortion in prices; if we visualize it in rounds of credit expansion, as the first round is making its way through the economy to everyone, the second round enters, keeping the buying power of some individuals artificially above everyone else. It is not until the Fed stops or lessens this continual pumping (usually when they raise the target interest rate) that the errors in relative pricing begin to be revealed.

3

I still stand by my description of nominal wealth as an ‘IOU’ or ‘claim ticket’ on the ‘pot’ of real wealth.

Real wealth is comprised of values that are consumed. Nominal wealth cannot be consumed, only traded. (so real estate is consumed in the sense that each period of time that passes is a lost ‘use’ period for that real estate)

Any monetary strategy of economic intervention, if I’m not mistaken, seeks to influence the distribution of ‘claim tickets’ to incentivize producers to increase the size of the ‘pot’. Or, on occasion, simply distribute ‘claim tickets’ to underproducers who otherwise wouldn’t have access to credit.

With such manipulations - extending credit to counter-balance a debt deflationary spiral - I have to imagine that the value of credit for credit’s sake could eventually be distorted beyond the value of actual real wealth.

That is, possessing access to the institutional means of recycling and multiplying nominal wealth would ultimately produce more ‘claim tickets’ than producing the real values they have claim upon. So fewer and fewer will be producing (the dismantling of the investment cycle), yet all will be clamoring for greater access to what real production is left.

I would predict that certain economic interventions: wage fixes, antitrust laws, barriers on energy production, would first lead to deflation, that the Fed could counter this deflation with monetary policy, that this would provoke a bubble, which would pop and lead to incredibly rapid deflation, countered by more aggressive monetary policy, until the point of a sovereign debt crisis (where the claim tickets become so worthless that the institutional recyclers don’t even want them), at which point there is sudden and disastrous hyperinflation as the massive stockpiles of cash are dumped for what little value they can claim.

In short, I can’t help but perceive any kind of monetary intervention to be some sort of institutionalized economy of pull. If the power to manipulate nominal wealth is created, who excercises it, and what actions should they take? Without that power, the market determines the different values of things. With that power, people do. And so the ear of the right person can become more valuable than the values in the market. And it’s only inevitable that the money itself would become more important to the chief financial institutions than the actual real wealth it has claim upon. More money means more sway with the masters of money.

It almost makes you wonder if it isn’t some scheme. Granted, even the most brilliant minds can make stupid mistakes, but I’m a little weary of the thought that so many could be so stupid for so long.

But there is no evidence for this, only a lack of evidence against it. So, until the Fed receives a proper audit, I have no reason to believe there is NOT some scheme going on.

That, I think is the prudent course of thought. And it’s falsifiable. A simple audit will answer the question. Among other solutions.

4

To add something to this…

…the Fed … continuously pump new credit in order to maintain this rate.

True… all of it. To add something to this…

I think it important to understand how non-monetary government policy and the private sector gets in on the expansion. I think this is particularly important for Objectivists to do. It is not unreasonable to hypothesize that Freddie, Fannie and the FDIC had as much a role in the recent housing/credit bubble as did the Fed in its control of money-supply. I think the biggest epistemological problem that the Monetarist school introduced into economic thinking is an over emphasis on monetary policy, combined with popularizing an over-simplified version of the Quantity theory of money.

5

The term “inflation” is used to mean two things: a rise in prices and a rise in the quantity of money. One can try to use it to always mean one or the other, but one still needs a term to use when talking to others (it is unfortunate that there is no other word to describe “price-rise”). Anyhow, that is about convincing others. Before that, one has to form one’s own conceptualization. I think of it as follows:

Prices tend to rise when there is an expansion of the money supply. This is an abstract form of the so-called “Quantity theory of money” (Aside: I think this is the level of abstraction that is valid, while trying to get more more detailed, with P x Q = M x V, is potentially misleading.) At that level of abstraction, the quantity theory of money is a restatement of the ordinary Theory of Demand: when there is more of something, its price declines. When there is more of money, it’s “price” – in terms of other goods and services – declines… and the price of other goods and services (as expressed in money-- rises)

The correct formulation is: when the supply of money rises without a corresponding rise in demand at the current value, the value of money declines.

Inflation is an unfortunate term, as it wants to relate to the increase in prices and the causative increase in money supply. The definition that limits itself to the money supply ignores the primary motivation behind the concept, which is price effects. In a commodity-money economy, the money supply increases when the goods-value of the commodity (e.g., gold) rises significantly above the cost of production, due to an increase in demand for money. Thus the money supply increases with the demand for money at the current value, so as to keep prices relatively stable. Even enhancements in the efficiency of production, such as that seen in the late 1800’s with the introduction of the cyanide method of gold extraction, do not tend to have a long term inflationary effect, since the increase of efficiency of gold production, in general, tracks with the increased efficiency in all other productive endeavors.

The most useful definition of inflation is the increase in money supply above that warranted by the demand for money. This recognizes the cause of inflation, while focusing on the relevant effect, which is the general increase in prices.

I don’t think you can talk “real wealth” v. “nominal wealth” except to reference current wealth to a nominal value of that wealth at some (prior) point in time. The term “real” simply means “adjusted for a measured change in the value of money.” That change is measured in terms of some arbitrarily chosen goods, whose prices have changed over time.

One of the biggest holes in our conceptual framework of economics is marginal value of wealth, which tends to decrease far faster than the inverse of total wealth. For instance, the first ~$400 of annual income is required for survival. The value of that $400 is effectively infinite, the value of the second $400 is vastly greater than the value of the second $million. The former is the difference between day-day survival and a modicum of security; the latter is the difference between home location and brand of SUV.

The revenue-conscious gov’t does itself a great disservice by ignoring the decreasing marginal value of wealth. As wealth and income increase, the marginal value of an hour’s work decreases with respect to the value of an hour’s leisure. This is the reason why an increase in the tax rate results in a disproportionate decrease in earnings for the rich, vs. the not-so-rich. If a theory of marginal values of income and wealth could be developed and applied to income and behavior it might help clearly explain why tax breaks for high-producers, possibly even a regressive income tax, might increase revenues.

6

It is not unreasonable to hypothesize that Freddie, Fannie and the FDIC had as much a role in the recent housing/credit bubble as did the Fed in its control of money-supply.

I agree, in fact, I believe that the effect of abandoning the deposit/reserve regulating effect on loans was the major cause of the bubble, aided in smaller part by the Fed manipulations. When Fan/Fred guaranteed mortgage-backed securities, they effectively removed the requirement for a risk dividend on ROI for MBS, providing market investors with an unbeatable risk-adjusted return on MBS and derived securities. The Gramm-Leach-Bliley Act of 1999 led to no private MBS’ until 2003, a lag of four years that is inexplicable except for the fact that the gov’t’s guarantee of Fan/Fred MBS made it impossible for private concerns to offer similar risk-adjusted returns - or mortgage rates to borrowers, on the other side of the coin.

I believe (though have seen no direct evidence) that somewhere in the early 2000’s, the gov’t gave implicit guarantee to private MBS’s in order to increase home-ownership and remove the appearance of a Fred/Fan monopoly. It was with such a guarantee that the ratings agencies were able to justify high-quality ratings to private MBS, against all logic. The fact that the government jumped in to help out with those overpriced securities is the only evidence that they had secretly signed on to guaranteeing all MBS’, not just Fan/Fred’s.

It was the flood of cash into banks from wall street, replacing mortgages on their books, and eliminating the need for reserves, that decoupled mortgages from their historically low risk norms. The failure to recognize that risk had fundamentally changed was what led to the overvaluing of mortgage-derived securities, and of bank-held mortgages.

7

The Lexicon states that inflation is not caused by the actions of private citizens, but by the government: by an artificial expansion of the money supply required to support deficit spending. No private embezzlers or bank robbers in history have ever plundered people’s savings on a scale comparable to the plunder perpetrated by the fiscal policies of statist governments.

The Federal Reserve continues to deliver us these ‘boom and bust’ cycles under the guise of ‘maintaining stability of the financial system’.

8

Is there a term that covers the increase of money for other reasons, for instance, under a gold standard, the discovery of a huge gold deposit that results in a general devaluation of money? It would seem this would have to be considered inflation as well, lest we allow connotation and motive, rather than denotation and cause to define our terms.

9

Yes, in a few cases during history, the discovery of a readily enough available supply of gold have been made to have identified the price-rise relationship to the quantity of gold available. This, however has been a rarer instance than the ability to observe the same phenomenon in the fiat systems currently enjoyed historically as well as currenlty.

10

Certainly true… but I have in the past seen people claim that this is impossible as a matter of principle. (Not in this thread, or I’d point to an example.) In point of fact if any expansion of the money supply is inflation (not just expansions sufficient to cause general price increases) then under a gold standard *any* mining of gold above replacement of lost gold (or gold worn off the coins) is inflation.

(how can an increase in supply not cause a price increase? if the economy grows at the same rate as the money supply, prices will tend to stay stable–of course some things will decline in price due to increases in their supply, or innovations, and others will go up due to shortages, e.g., a lower-than-expected harvest.)

11

(how can an increase in supply not cause a price increase? if the economy grows …

That’s the typical process. More rare is where the demand for money increases. The demand for money can increase in a way that balances out the increase in supply. (The way this is expressed in the typical Economic text would be by saying that the velocity of circulation decreases; but, this is a less clear way of saying that the demand for money increases – von Mises has a good critique on this.)

12

From another thread…

To the OP, do I gather you disagree that inflation is driven by monetary policy? Is there an alternate theory that you subscribe to?

This “great recession” has been a blow to the strictest, narrowest and most linear forms of the “Quantity Theory of Money”. von Mises was pretty critical of the theory in that form, but every text book has it, and post-Friedman it has become part of pop “knowledge”. People think “the Fed is creating money”, so prices will go up.

 

I think of it as the vengeance of ceteris paribus. The simplest forms of the theory were okay for intro text, ceteris paribus; but, it was so drilled in that the various conditions subsumed under certis paribus were ignored. 

13

Regarding how credit increases inflation, in the OP:

Without the banking sector’s money or the Fed’s money, if I extended credit, without anything to back it, would I be, in effect, expanding the overall money supply?

And if so, would it contract to the prior level as I was repaid?

14

On my second question (above) I meant to ask, if my first question expanded the unbacked-by-production money supply (& say I sold a consumable that couldn’t be repossesed), would the expansion I caused become money-now-backed-by production as I was repaid?

15

My (above) questions were an attempt to provide a concrete for my ultimate question regarding how expanding credit expands the amount of money “in circulation” (if I understood OP):

Different from how the Fed keeps a record of their increases of the monetary supply when they extend credit, can an inflation-causing increase also include when a citizen, without anything to back it on his end, gives out an unsecured line of credit? (Implying there would be more money in circulation than what’s on the Feds books.)

16

If US exporters saw a massive increase in demand, & assuming they wanted payment in dollars (which would increase the value of the dollar), what would be the effects on prices for the things I buy in the US?

17

Credit expansion is not identical to money expansion. However, banks are able to create new bank money (notes and deposit balances), which are treated as “near money” or even as money substitutes.

Long answer:

When a person borrows money from a bank to buy a car, what is the underlying “net” transaction? One traditional model – particularly under a gold-standard – conceptualizes this as follows: someone who has some real value (i.e. gold) gives it to the bank, and the bank then lends it to some borrower, who then buys something with this. In this model, instead of the saver buying the goods, the borrower does so (using the saver’s saved values). This model would net out the impact and say that there is no difference in “aggregate demand” just because a different person does the spending.

This model does not explain things well, even under a system where we have no fractional reserve, but I’ll ignore that. We do have a fractional reserve system. This system existed even under a gold standard, so it is not about the FED. In a fractional reserve system, a bank creates money in the form of bank-obligations: either bank-notes or deposits at the bank. Most economic text books says that when a person deposits $1 in a bank, the bank “multiplies” this, creating (say) $10 of bank-money (assuming a 10% reserve ratio). The idea of a multiplier has problems, but we do know this much: except for emergency situations, fractional-reserve banks create bank-money, over and above deposits. (They do this in two ways: one way is by monetizing assets, the second is by monetizing future values.)

Imagine a car dealer has certain demand for his cars. If banks decide to lend more on cars, and if consumers are willing to use such loans, this creates new marginal-demand for cars. Banks and consumers are able to do this without curtailing their purchases elsewhere. Obviously there are limits to what either will be willing to do, but the point is this: the level of credit is not some sort of fixed sum based on an economy’s productive capacity. It is the product of another layer of borrower and lender decisions, overlaid upon productive capacity.

In other words, an increase in credit can increase nominal aggregate demand. If and when credit contracts, it has the opposite effect.

18

 

From another thread…

 

This “great recession” has been a blow to the strictest, narrowest and most linear forms of the “Quantity Theory of Money”. von Mises was pretty critical of the theory in that form, but every text book has it, and post-Friedman it has become part of pop “knowledge”. People think “the Fed is creating money”, so prices will go up.

 

I think of it as the vengeance of ceteris paribus. The simplest forms of the theory were okay for intro text, ceteris paribus; but, it was so drilled in that the various conditions subsumed under certis paribus were ignored. 

 

 

Yep, certain politicians took a soundbite out of some complex theories and used the dumbed-down (and ultimately false) version of it for political gain. Politics as usual.

 

The question is, who was there to guard against this? Where were the intellectuals who actually do live in nuance and should be there to clarify things and correct the falsehoods?

 

My general assessment of the answer is that those intellectuals made a deal with the devil–they packaged some positive ideas up with some false ones in an attempt to get their positive ideas in front of more people. Now their positive ideas will be thrown in the proverbial garbage along with the obviously false ones which actually deserved such a fate.