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This post reminds me of classic asset/liability mismatch risk of banks. Back in the days when interest rates were positive, the classic mismatch was fixed rate assets against floating rate liabilities. The “mismatch” risk was that a bank could get caught by rising rates.

Now substitute inflation for interest rate sensitivity, and households for banks. If you capitalize expected household income and expenditure as a near term balance sheet, then it has assets that include expected wages and liabilities that include expected expenditures. If inflation hits those two sides with different timing, then you have a mismatch risk comparable to bank interest rate risk. If wages are sticky but prices go up, the household will get caught in the mismatch by rising inflation.

In both cases, it’s the risk associated with timing differences, and how that hits individual balance sheets, not the level of interest rates or inflation per se. Although large first derivatives, i.e. changes to interest rates or inflation, exacerbate that timing risk.

"an invalid argument can sometimes have a true conclusion"

Perhaps your "fallacy" is actually just a heuristic: a useful simplification of a complex phenomenon. For instance, you argue debt is neutral. Why do people insist it is bad? Perhaps because they sense that there are such things as financial frictions and different consumption propensities (across income levels) at work. Most people don't know how to have that discussion, so they rely on an infuriating (for economists) rule of thumb: "it is bad for society to borrow too much".

The raison d'etre for technocrats is that the employment of common economic heuristics leads to suboptimal outcomes. The counterargument is that apparently suboptimal heuristics may be useful safeguards against the creation of an fragile system prone to tail risk.

"It's so easy to get popular support for the idea that printing money will cause inflation, and inflation means a fall in our real income."

To a lot of people, inflation **means** an increase in the money supply.

To even more people, perhaps most, inflation **means** a fall in real incomes because prices increase faster than incomes.

These two meanings are common in informal, everyday speech. I don't know if fallacy is the right word for that fact.

A lot of people believe that an increase in the money supply will lead to prices increasing faster than incomes. That, of course, is a fallacy.

Well, economists have to confess to their role in all this, Nick. Milton Friedman and his followers spent their careers arguing inflation was bad. People and politicians believed them. In response to high price inflation in the late 1970's we had very high interest rates in the early 1980's. That was before my time, but I have noticed a very prevalent view among those who remember that time that the high price inflation and high interest rates were "bad" and to be avoided at all costs.

We have a generation of economists who focused on justifying an explicit 2% inflation targeting rule for the Bank of Canada and explaining why this is a Good Thing, both to the academy and to the general public.

Economists went along for the ride as much as the rest of us did. You even took your turn in the driver's seat. So you can't complain when you don't like the destination.

Now I'm game for saying that we do need to change our focus and we need to realize we are in a poor economic environment, poorer than we have seen in several generations. But let's all remember how we got focused in the first place.

But I don't have anything to sell, I buy with money I have saved, if you reduce the value of my savings, more and more my savings are being stolen.

A bit OT but delong censored it on his blog, so I'm trying here too:

Ghost cities in China supported AD/CPI/employment, you name it, for years. Good or bad? And should we emulate that?


* your inflation argument makes sense "maybe" in a closed system. just like keynesianism.

Are you sure that inflation is not a good thing? The first hockey stick graph I saw was one that showed inflation taking off around 1750. It seems that there are two different monetary regimes, pre-industrial and post-industrial, and inflation is characteristic of the latter. Is that mere coincidence?


Old joke:

A politician on the stump declaims:
"My friends, I am against inflation." (Applause.)
"My friends, I am against deflation." (Applause.)
"My friends, I am for -- FLATION!"

Old Art: "I buy with money I have saved, if you reduce the value of my savings, more and more my savings are being stolen."

Take your money out of the mattress and buy TIPS (Treasury Inflation Protected Securities).

"Sometime in February, I will ask my ECON1000 students: "So, why is inflation a bad thing?"


"Finally one will answer.

"Because if all prices rise 10% we will only be able to afford to buy 10% less stuff. Duh!" Except the "Duh!" is silent.

"That's the inflation fallacy."

What if you then ask them what they mean by inflation? That might save you a lot of trouble. :)

Determinant: "Milton Friedman and his followers spent their careers arguing inflation was bad. People and politicians believed them. In response to high price inflation in the late 1970's we had very high interest rates in the early 1980's. That was before my time, but I have noticed a very prevalent view among those who remember that time that the high price inflation and high interest rates were "bad" and to be avoided at all costs."

I don't think that you can fault Uncle Milty. He thought we should have a steadily increasing money supply, right? He also convinced Nixon to go completely off the gold standard. (If only Congress was aware of that fact!)

Inflation is bad because it reduces their real income. What reduces the real income of others, unemployment, is not their concern, or even, a buying opportunity.

I expect that people could be trained to accept any reasonably predictable inflation rate as "good." It seems to me that something a bit higher than the current target would probably have some advantages, and may actually help with inequality - in general, lenders are part of the wealthy classes while borrowers are lower on the pole. Increasing the inflation rate could be sold pretty easily as a wealth transfer, if there was a desire to do so. It would only work on existing debts, of course. It should also help encourage investment generally, since sitting with your cash in a mattress becomes more expensive.

It's unpredictable inflation that seem like a bad thing. I would expect it to cause trouble in debt markets, since lenders and borrowers no longer have a good prediction of what their real returns/costs will be. I might be less likely to borrow at 5% if I can't reasonably expect to get a 2% inflation discount on that. Likewise if I had money to lend, I'd want a higher rate to cover the risk of much higher inflation.

"I'm an expert on what non-economists think about economics."

Great line.

"Inflation is bad " because everybody ( including the statisticians) confuse it with real price level. The '70's were not inflationary. They were contractionary They were a time of real shock ( oil) and subsequent fall in real wages. But we viewed it as a "recession", tried to use stimulative measure and ended up with a higer price level that we conofused with the cause of the problem. ( Though as a benefit, inflation brought back the terms of trade with the oil producers more in liine with the pre-schock equilibrium)
But the damage was done. And the hard-money types had a new "reason" to fight the welfare state

Most lay people use the term inflation to mean a price change, any price change, or often as is the case, price changes that bother them, e.g., sharp increases in food or fuel prices.

The notion of economy-wide weighted price changes is a tough one to grasp.

I vote for 0% inflation target with a -1% to +1% operating band range. As the socially responsible thing to do given to what extent folks are too readily confused by price changes. Higher inflation rates provide smart, nimble folks opportunities to make money in the markets. Socialism doesn't mean having to make rich bond holders and others richer but I suppose there could be worse outcomes.

Lord, if I find out that Nick has committed suicide in the night, I am holding you personally responsible.

Given the nominal quantity of money, a 10% in the price level reduceds the real quantity of money by 10%. Given demand for money, you are short and the way to fix that situation is to buy less. Must you buy less? I am not sure, but the expectation is that people will want to buy less. And so firms will sell less.

At least, that is the way I see the effects of an "inflation" shock.


A stimulating argument, good food for thought. Still, I think there are some problems here.

* Doesn't your account assume a closed economy? In particular, unless wages or other inputs into a firm's tradeable goods can be reduced to offset rising prices, wouldn't that firm find, over time, that it is losing customers at home and abroad to competitor firms in countries with lower rates of inflation? Or is the inflationary economy supposed to see its currency adjust quickly downward?


* If the home-currency is falling steadily (compared to competitor countries' currencies), won't that further feed back as higher-costs of imported inputs to production in the home-country and cause ever higher costs to the finished goods? Or --- maybe just as bad, since currencies can undershoot or overshoot all the time if they're floating --- at least might there not be more and more uncertainty in various firms's investment decisions for the future? Might not many of them decide to relocate abroad where wages and prices are steadier or more predictable (and likely lower)?


* Savings: Sure, there are ways to offset rising inflation such as TIPS. But then won't the need for savers --- including those in retirement living on savings and fixed pensions --- incur lots of opportunity costs in managing their portfolios. And exactly how many average-educated people, never mind others in such a situation, know how to find the right way to manage inflation? Especially if uncertainties about future rates of price-rises begin to multiply?

* Market Power of certain labor forces: You assume that wages will, it seem, adjust pretty quickly upward to offset, say, even steady inflationary tendencies. Is that assumption true of all employees, in both the private and public spheres. Won't unionized workers be able to extract quicker adjustments in wages from management (private or public) that those who aren't organized? Which is way,when you get down to it, that powerful unions didn't seem to mind higher inflation rates in the past in the USA . . . at any rate, until international competition in, say, the auto industry began to make more and more USA auto sales fall over time (apart from quality questions).


* You ignore the political side of all this, or so it seems.

Specifically, you assume that the Central Bank is private, that it won't be subject to political pressures from elected governments to raise the money supply (and hence, let us assume, NGDP and overall prices) for self-centered or ideological reasons. Are you sure that this is the case? Wouldn't uncertainty begin to creep into the savings and investment and consumption decisions of economic actors, convinced that at some time even in the USA or Canada, legislatures might revise the charters of central banks and make them more susceptible to political manipulation.


* Menu Costs. Various retail and service firms would have to incur repetitive costs yearly (or more frequently, all depending on whether rates of inflation vary over the year up or down) to adjust their prices. Couldn't that add real costs to their products?


* Finally, to get back to unpredictable changes in inflationary rates --- leaving aside hyper-inflation, the definition of which will vary, seemingly, across countries for historical reasons (think of Germany vs. Italy or Greece today).

In particular, are you really sure that the Central Bank in the US or Canada or the EU or elsewhere can, once expectations of the average economic actor adjust to a certain inflationary rate, can maintain that rate in the face of all sorts of exogenous and unpredictable changes: wars in the Middle East and sudden spikes in oil prices (or any huge spikes as in 2007-2008)? Or a sudden surge in other raw materials and food, maybe owing to bad harvest or natural disasters (like the nuclear reactor breakdown in Japan recently) or unpredictable changes in "animal spirits" of home and foreign financial investors if a country like the US or Canada is experiencing sudden spikes, however temporary, and begin to set off a run on that country's currency --- itself self-feeding possibly.

Rightly or wrongly, for historical reasons --- to return to Italy and Germany --- have created far different outlooks not just among average people without economic backgrounds, but among policymakers . . . including intelligent Central Bankers. Maybe the German-influenced policy-ideas in the EU today are wrong. Maybe they will have to bend in the future, though just as likely the Germans will find ways to reorganize the Eurozone membership or policies. Are you sure that, given their historical experience with hyperinflation in the 1920s --- which did wipe out the savings of average people and voters and turn them against the Weimar Republic (which solved the hyperinflation with a new currency) --- the Germans are just subject to a fallacy?


Always enjoy your posts, Nick. This one too.

Best, Michael Gordon, AKA the buggy professor


Your comment that most people view inflation as price inflation and not wage inflation is the key. If wages are flat but inflation is 10% then you are worse off and that's a situation that most people identify with without seeing the link between price and wage inflation. When inflation is 10% and wages are rising at a rate of 10% people think they "earned" that 10% raise and if only inflation wasn't 10% they'd be better off without realizing without 10% inflation they would never get that 10% raise in the fist place.

Also, why do savers always manage to find a way to complain. Either inflation is too high so it eats into their nominal interest or their nominal rates are too low, without ever realizing that their real rate of return is more or less constant.

Finally, unpredictable inflation is probably bad as it hinders planning and inflation variability seems to be positively correlated with the actual rate of inflation, so even though 10% inflation is not inherently worse than 2% inflation, 10% plus or minus 4% is worse than 2% plus or minus 1%.

It depends. A little inflation is a good thing most of the time for most of the people. "Too much" inflation is a bad thing most of the time for most of the people. How much is too much cannot be specified in advance. Any absolute statement about inflation is a fallacy of hasty generalization.

In the 16th and 17th century there was not enough inflation in Europe and it was strangling their economies. Kings were commissioning alchemists to try to solve the problem through the creation of artificial gold. The deflation problem was solved instead by the institution of credit money.


Uncle Milty was also personally responsible for the American Welfare State and Big Government as we know it, he designed and implemented the payroll witholding regime for Income Tax that enables fuels Big Government.

But the Inflationphobes flocked to his standard; we spent the next thirty years putting them in positions of power. Now we reap our reward.

Of course Uncle Milty himself was contradictory but he was the star spokesman for the "I Hate Inflation, let's have Free Markets" club.


I love it when you post about the 1970's because I always agree with you.

The salient fact is that the United States reached domestic peak oil production in 1970. After that domestic oil became scarce and the US became dependent on oil imports to meet full market demand.

Sure much of the actual oil shock was political with the closure of the Suez Canal but depleted natural resources made the crisis possible the first place.

But according to Nick aggregate supply shocks don't happen outside of war. Ummmmm.....

Another great post Nick. You are on a roll.

My first thought is to something Old Art said;

"But I don't have anything to sell, I buy with money I have saved, if you reduce the value of my savings, more and more my savings are being stolen."

This is the Austrian position, one that gives the *saver* primacy over everyone else. I think it was someone at Steve Waldmans site that talked about how savers seem to expect that they should never be on the bad side of the economy. When labor has to suffer low unemployment; "Well, its just that the marginal return on labor is falling and well you'll just have to suck it up" But when the interest rate heads toward the negative " Danger Will Robinson Danger Will Robinson!! Those poor savers are being punished, we cant have that!!"

Look, sometimes its just a bad time to save.................. deal with it!

I assume we are talking about a domestic basket of consumer goods. Much of the basket is imported so is not "my" output. So inflation is bad. This is generally true even in China, but almost 100% always true in Luxemburg. Domestic producer price inflation however is a good thing because some of it is exported. The converse is true for foreign inflation: CPI good, PPI bad. But if you ask me the question you ask your students, I'm going to assume you refer to *domestic CPI*. That's the common meaning of "inflation." And I'd say "bad."

David Pearson: "For instance, you argue debt is neutral. Why do people insist it is bad?"

They used to put some debtors in prison, you know. Where are the creditors' prisons? ;)


I'm sorry to find out that you expunged my comment. I expect Delong to censor comments that criticize his views; the man's egomania can't tolerate them. Mark Thoma, who runs a good blog, has,alas,started to show temper-blasts of late too. They both want,apparently,only bah-bahhing sheeple who bray their approval, nothing less. A good way to massage their narcissism, no?

Then,too,The libertarians at EconLog,to their shame,have shown that they can be as intolerant of hard,evidence-driven criticisms as left-wingers,politically correct to the core, and in bad ways, tend too often to do.

But I never expected you to emulate their censorship, just the contrary. It seems a shame . . .doubly so since I share you overall commitment to fight serious inflation by means of NGDP monetary policy.



The Creditor's Prisons are located next to the Customer's Yachts.

Michael: Your post was the victim of an overzealous spam filter. Our apologies.

I always thought inflation was one of those things rich people disliked, so they made sure to spook the rest of us into not liking it either. Like taxes.

My understanding is that money is just debt, like any other financial product. It's backed by the tax payers of the country who issued it, and gold was commonly used as collateral. You trade your apples for an IOU from society.

The printing of money means the dilution of debt, which means the lowering of its value, which means inflation, which means those with money have lost. Rich people don't like that. The debt is being forgiven, but not forgotten.

And for us rubes, living paycheck to paycheck? Inflation means nothing. And frankly, we don't even pay much taxes! There's freedom in having nothing to lose.

Determinant: "The Creditor's Prisons are located next to the Customer's Yachts."

Great minds think alike. ;)

I agree. (I guess that's no big surprise.)

This is closely related to points made by JKH and others, but if price dispersion is correlated with the rate of inflation then the fallacy is not a fallacy.

As Nick says, people are consumers of many goods and sellers of just one. By some law of large numbers, any consumer can expect her average costs to closely track the inflation rate. However, while on average earnings rise in parallel, the dispersion of any consumer's earnings around that average is large. She may receive a windfall, as her earnings outpace increasing costs, or she may find that her wages fail to track the price change. If she is risk averse, she prefers the low price dispersion that accompanies low inflation.

Ironically, if she is leveraged (directly via loans or operationally via high not-very-discretionary expenses relative to income), she will be particularly risk-averse. If she is leveraged via fixed nominal debt, she'll need to trade off the riskiness of price dispersion against the benefit of an expected reduced debt burden. If she is leveraged by lifestyle, her burden rises with inflation, so all she experiences is acute risk.

If our consumer's wages are sticky downward and she is secure in her employment, then it's likely that inflation will correspond to a real wage cut in expectation, not just unpleasant but symmetrical risk. This consumer's "shadow wage" — the wage that would obtain under flexible pricing — might be lower than her money wage, but be censored by the downward stickiness. Inflation exposes her to the risk of taking a pay cut towards the market-clearing level. Even if our consumer's sticky wages start at the "right price", higher inflation reduces a favorable asymmetry in the distribution of her future wages since her nominal wage cannot fall.

I would love to see a nice wage-price cycle take hold right now to reduce the burden of nominally contracted debt. But it is not stupid for people who are not financial creditors but hold secure jobs to dislike inflation, once you add uncertainty to the analysis. Those of us who want looser money are advocating an increase in risk and probably some loss of wealth for this group of people, even if the distribution of market-clearing wages shifts upward just as much as the distribution of goods prices.

It is people whose employment is uncertain or nonexistent and people who are significant financial debtors who most surely benefit from a general inflation. But these are groups with less political clout than financial creditors and the securely employed, for whom risk avoidance rather than wealth maximization is the most pressing concern.

Sandwichman: In the 16th and 17th century there was not enough inflation in Europe and it was strangling their economies. Kings were commissioning alchemists to try to solve the problem through the creation of artificial gold. The deflation problem was solved instead by the institution of credit money. Please look up any reference to "the Price Revolution". Increased silver production from Central European mines and then American silver flooded into the European economy. In the early C16th, there was an expansion in paper credit instruments. In the mid C16th, England and the Netherlands greatly debased their coinage. The combination of these factors led to sustained price rises as expansion in the money supply continually outpaced output.

There was a "bullion shortage" in the mid C15th, but technological advances (better pumps and ore separation techniques) made Central European mines productive again.

Jacques René Giguère: The '70's were not inflationary. They were contractionary They were a time of real shock ( oil) and subsequent fall in real wages. Spending continually outpaced output at a considerable, if variable, rate. That led to considerable and continuing rises in the price level: to most people, that's inflation.

The problem with your statement is that the opposite of 'inflation' is 'deflation' and the opposite of 'contraction' is 'expansion'.

Whatever policy is chosen, there will be winners and there will be losers. If a higher inflation rate is chosen, individuals who are borrowing at a fixed rate or dependent on income from real goods that appreciate during inflation (e.g., oil) will prosper, while those who are lending at fixed rate or dependent on income that lags inflation will lose. Indebted governments will win, at least at first, as the debt they've issued at fixed rate is inflated away, but eventually interest rates will rise and this advantage will be lost. The beneficial impact of inflation will vary across the people and institutions of the economy.

So when considering the impact of higher inflation, the question shouldn't be whether on average the economy will benefit but rather whether the majority of the people in the economy will benefit. Or perhaps, whether the negative impact on the segment of society which will lose under the new policy can be justified by the gains of those who are well positioned to take advantage of the new regime.

I believe this is the basis of many of the left's suspicion of NGDP targeting. It is unclear if the policy will benefit everyone in society, and in particular whether it will benefit the middle class. Rather, the fear is that a small subset will gain from the higher inflation at the cost of the majority.

No one seems to have mentioned the obvious drawback of excess inflation, namely the bureaucratic costs it imposes on businesses and every other institution, public and private. If everyone has to adjust their prices once a month rather than once a year, that is a significant administrative burden. As to carting around wheelbarrow loads of Reichsmark notes as during the Weimar period, that is hardly an efficient way of doing business.

Re Min’s suggestion that anyone worried about inflation can buy TIPS, I’m not sure about the details in the US, but in the UK, the volume of inflation proofed government bonds is restricted. Moreover, buying inflation proofed bonds in the UK is a bureaucratic process and I would imagine 90% of pensioners have no idea how to go about it. In short, inflation robs savers, pensioners in particular.

Inflation has well known costs and benefits and a 2% inflation target simply represents the existing consensus on the best trade-off between those costs and benefits. The problem is that this trade-off may no longer be optimal if the natural rate of interest becomes negative (for example, the classic Taylor rule with a -1% real interest rate and a 2% inflation rate leaves virtually no room for countercyclical monetary policy) and needs to be reevaluated, but it may take a while for a new consensus to emerge.

Great post, Nick.

Ralph: "inflation robs savers, pensioners in particular"

Pensioners are surely dis-savers, not savers, by definition. How many pensioners really rely on income from fixed income bonds? It would be interesting to see some stats. I'd wager not many. At least in the uK:

a) the state pension has always been linked to a price index, now earnings too
b) defined benefit schemes always link payments to a price index (by law I think?)
c) those with DC schemes can always buy index-linked annuities
d) National Savings (the govt) has offered index-linked savings bonds at retail forever. Though they've withdrawn from that market at times over the last couple of years, due to high demand, commercial banks have started providing similar products.

I agree that inflation is not that terrible. Menu cost are not that great (especially in the internet age). But variable inflation is a pain as it's diffucult to predict and I think most people identify high inflation with high inflation variability.

I think there is also another side on the equation: people like risk-free assets. And NGDP-targeting would reduce the safeness of nominal bonds (which are the main safe asset). Any real shock in the economy would result in a depreciation of nominal assets. Only inflation-linked bonds would be the "safe" asset. That's a big change. It's the basic agreement between bond-holders and equity-holders, equity takes the upside and downside... In nominal targeting bond-holders take a lot more risk because economy wide shocks will hit the bondholders more directly. You could argue that it's an illusion since they are just trading highly variable default risk for much more gentle inflation depreciation, but I don't think people see it that way...

Also one could argue that the additional cost of default in the current framework are much higher than inflation menu cost (and I strongly believe that point). But that's not what people think. They want something that stores value and it's hard to convince them that it's counterproductive...

I think acarraro has it right - it is not inflation that is the problem it is variable inflation (i.e uncertainty about what real prices are).

I'm surprised no-one here has put this in a simple behavioural / availability / Kahneman-Tversky framework.

We have simple brains, trained to notice things that change, and to ignore things that do not change. Just as importantly, to notice things that cause us pain (price rises) and not to balance against things that benefit us (or to discount them).

Even in a zero inflation situation, if things are changing, prices will change. Some will go up, some will go down. People notice and complain about the prices that rise, but do not comment on prices that go down.

I have seen this in action personally, living in a quasi-dollarised economy. Whichever direction the foreign/local currency goes, people only ever comment on the resulting changes that harm them. Dollar goes up? We can now afford less dollar-based stuff. Local currency goes up? The dollar contracts we had before are now worth less. (Many more examples possible but I see variations on these inconsistent responses all the time)

Can it be that a non-zero inflation makes it easier when relative prices of goods have to change, due to some structural or external pressure, or a political motive to increase or decrease in incomes? A low inflation makes it more difficult to change the relative level of sticky prices. A higher inflation makes adaptation of relative prices somewhat easier: it forces relative pricing of goods to be renegotiated, at the rate of inflation. Having to renegotiate all the time is a hassle, and takes away attention and energy from 'normal' productive processes. So too much inflation is obviously bad. But with changing scarcity of resources, or political pressure to improve social inequality, it may help to force the renegotiation of certain relative prices that need to be changed.

The median salary for a full-time worker in the UK rose 1.4% in 2011 to £26,244, against a headline CPI inflation rate of 5% or higher, according to the Annual Survey of Hours and Earnings from the Office for National Statistics. Overall earnings growth was even lower, with the average UK salary increasing just 0.5% on 2010 levels once part-time workers are included.

Perhaps you should explain this to the ONS?

Because clearly, if the empirical observation disagrees with our axiomatic principles, the observation must be wrong.

Sorry for not responding. I've been a bit busy.

Sorry about the spam filter, everyone. (I found one of Kosta's old comments on another post, and think I managed to publish it).

One very general point: Look, there are dozens of arguments for and against inflation. Some are good arguments, and some are bad arguments. The "inflation fallacy" is just *one* argument. And it's a bad argument. It's invalid. That doesn't mean *all* arguments against inflation are bad.

Returning later. Gotta do a lot of admin stuff. Hangover of committees I was on when I was a semi-real administrator.

Alex, that is exactly my point about CPI being more input than output in an open economy. Which is why Nick's students are right.

It wasn't that long ago that I was in an intro economics class, and I might have answered your question the same way as your hypothetical student.

Here's the thing, though. If you had asked, "What happens if the government passes a law that raises all prices by 10% and adds a zero to every bill?", I probably would have said that nothing happens.

So maybe Bill Woolsey is on the right track. People believe the inflation fallacy because they are thinking about what happens to their stock of money, not their flow of income.

Whichever direction the foreign/local currency goes, people only ever comment on the resulting changes that harm them.

This is very true. I was in Austria for the deployment of the € notes and coin, and although inflation didn't actually go anywhere, everyone was convinced it had soared, and of course people were full of friend-of-a-friend stories about café prices. Prices had been double-labelled for months, and of course, € monetary policy had been in force for a couple of years.

Okay, in Nick's absence, I will point out that restating the inflation fallacy is not the same thing as explaining why it is, in fact, correct.

For example, why are you assuming that changes in consumer prices and changes in wages are unrelated?

Actually you could argue that high inflation is bad for saving only if it's a surprise (and then potentionally only in the short term). I'll get compensated for it as long as I am willing to lend the money (even if taxes are a problem in this case as we are usually taxed on the nominal income rather than real).

And you need to think on a multi-year basis. It's like insurance companies: sometimes a disaster is not bad for insurances as it increases the demand for insurance and they can push preiums up above the true cost (it also allows them to spread fixed cost on a wider basis given higher demand).

The same could be true for savers: if inflation raises inflation premiums embedded in nominal rates goes up it could be positive for saver in the medium term (especially if inflation goes down more quickly than expected). Unless you have ever accerelating inflation that is...

But the variability is a true cost. We are risk averse... Variable inflation is bad as it increases uncertainty.

As for the UK inflation, that's not evidence: I think it's reasonable to assume that if the BOE had kept rates higher and killed inflation, wage inflation would be now negative (or unemployment massively higher)... Look at Spain (or Ireland) if you want counterfactual: do you prefer 20% unemployment?

Actually the tax argument is quite important... Given most tax system are nominal based, high inflation would increase taxes on saving and investment in an undesirable way...

It's probably more of an argument for changing teh tax system, but there you go...

Stephen: "For example, why are you assuming that changes in consumer prices and changes in wages are unrelated?"

Because they are only *partly* related. To the extent that the consumer basket is produced with domestic wages they are related. To the extent that it's imported, not so much. In the limit of a small open economy (independent of the trade balance) the relationship will be weak.

Here's another point: In a closed economy (and in the long run in an open one), there's a firm relationship only between income and the price of the consumer basket. But the relationship between income and median wages is weak (they've been diverging by over 2% per year for the past 40 years). Given sufficient technological development, it's entirely possible for *all* wages to drop to zero while the CPI keeps going up (all consumed by the owners of capital). So CPI can indeed suck for the vast majority of the population. (If that fact hasn't been fully reflected in the past, it's only because the CPI doesn't properly weight the price of private islands and foreign registered luxury yachts.)

I have no quarrel with the substance of what Steve Waldman said, but I don't think it vitiates Nick's interpretation. I mean, if I am collecting rents via a sticky-downward wage + secure employment my compositional fallacy is that I think I am better off in relative terms because I forget that others will do the same.

It remains true, as several people have observed, that when price levels change, or the rate which they change changes, there will be winners and losers. I believe that this is what provokes the anxiety manifested in most compositional fallacies: as Yossarian famously put it in Catch-22 when asked what would happen if everyone behaved the way he did, "then I'd be a damned fool do any different."

Compositional fallacies are uncomfortable for us to think about because if we think we are winners we feel guilty and if we think we are losers we feel, well, like losers. You see this in quite mundane settings. For instance, it is impossible to make the original meaning to stick to the word "gridlock"; it naturally evolves toward "traffic jam." Because who wants to think that the traffic jam that is delaying him is his own fault?

Money printing and inflation may be all well and good as a re-balancing (and declining standard of living) of U.S. and European labor. They have to re-balance one way or another.

It's most brutally unfair in picking investment winners and losers.....via financial repression of savers (what's the interest rate on a CD these days) and sophisticated investors who see the obvious hedge in real estate, agriculture and commodity based options.

If we want to talk about the Inflation Fallacy, let's define terms. What is inflation?

"Increase in the overall level of prices over an extended period of time."

-- http://www.babylon.com/define/35/Economics-Dictionary.html

"A persistent tendency for prices and money wages to increase. Inflation is measured by the proportional changes over time in some appropriate price index, commonly a consumer price index or a GDP deflator. . . ."

-- http://www.enotes.com/inflation-reference/inflation-594295 (The Oxford Dictionary of Economics)

Note that the Oxford Dictionary specifically mentions wages, while the other dictionary does not. That may be unnecessary, since the price of labor is wages, but in ordinary parlance a distinction is made between prices and wages.

Here is another definition.

"a. an increase in the amount of money and credit in relation to the supply of goods and services

"b. an increase in the general price level, resulting from this, specif., an excessive or persistent increase, causing a decline in purchasing power"

-- http://www.yourdictionary.com/inflation (Webster's New World College Dictionary)

Wow! That's almost two fallacies for the price of one. ;) Note the reference to decline in purchasing power in b. I think that most people interpret that as a decline in the purchasing power of people, not money. (After all, people are agents, not money.)

I think that b. pretty well expresses the common understanding of inflation: an increase in prices that causes a decline in people's purchasing power. What's good about that?

And it is not like we do not see that phenomenon. But that is not the technical meaning of inflation in economics, is it? The Oxford Dictionary definition is better, no?

I don't think it helps much to think in terms of simplified models that never occur in the real world. If all prices adjusted instantaneously and uniformly as a result of monetary changes, without any informational lags, costs or frictions - even the price of servicing debt liabilities - then it is true that inflation would be an utterly insignificant phenomenon. But real world inflation is never like that. Some prices rise more than others during any inflationary period, and the changes in price are diffused and communicated one to another via a complicated causal pattern. Every agreed price in the world represents a contract of some kind, and in a period of accelerating price changes with an accelerating average upward trajectory, all of these contracts are renegotiated and there will be many winners and losers. And it is entirely possible for their to be more losers than winners.

Whether any individual regards the prospect of some inflationary episode as a bad thing, even in the absence of any confusion about the totality of effects of the inflation, will depend on whether they expect themselves to be a winner or loser from the episode.

In the real world, even anticipated inflation is costly. Here is part of an Economic Commentary I wrote for the Cleveland Fed back in January 1992:

In what sort of world would inflation
be both predictable and neutral? Imagine
an economy in which the inflation
rate has hovered around 4 percent per
year for a long time. The central bank
is required, as a matter of law, to do
whatever is necessary to maintain that
rate forever. For all practical purposes,
there is no price-level uncertainty. Inflation
always was, is now, and forever
shall be 4 percent. Furthermore, the tax
code and all contracts are fully indexed,
and the entire population is
highly proficient at multiplying and
dividing by powers of 1.04. Although
some of these conditions sound a bit
silly, they are all needed to ensure that
inflation is truly neutral.

Now suppose that, for whatever reason,
the denizens of this economy decide
they want an inflation rate of zero. The
central bank is directed to pursue this
goal as assiduously as it previously
strove to maintain 4 percent. How
should the bank react?

It may elect to cut the monetary growth
rate by 4 percent, thus creating money
at a rate consistent with no inflation.
Even if the central bank is fully credible
and the reduction is phased in gradually,
however, the disinflation will create
problems. People who borrowed money
under the old regime will see a 4 percent
increase in the effective rate of interest
on their old contracts. They may
default as a result. Also in distress will
be employers who previously agreed to
muln'year labor contracts calling for annual
4 percent wage increases. Some
workers will have to be let go. Throughout
the economy, expectations will be
upset and resources redirected; a recession
of several quarters' duration may
ensue. Eventually, the economy will adjust
to the new inflation rate and grow as
before, but the transition will be costly.

There is no need for all this pain. Axel
Leijonhufvud has described a scheme that
can eliminate inflation with no transition
costs at all. The central bank creates a
new currency, the blueback, to circulate
alongside the existing currency, known as
greenbacks. The bank has absolute control
over the blueback-greenback exchange
rate by virtue of its willingness to
trade unlimited quantities of one for the
other. It uses this control to appreciate the
blueback against the greenback continuously
at a 4 percent annual rate. Since the
inflation rate in greenbacks is 4 percent,
inflation in terms of bluebacks is zero.
The courts cooperate by interpreting dollar
amounts as referring to greenbacks in
existing contracts and to bluebacks in new
contracts, so people continue to receive the
real value they bargained for. Eventually,
the greater convenience and lower opportunity
costs of dealing in bluebacks result
in the withering away of greenbacks.
Unlike the first disinflation scenario,
however, the transition is costless.

It may be argued that a blueback scheme
could not be implemented so easily in a
complex, real-world economy like our
own. Indeed it could not, but the reasons
why are grounds for doubting that our
current 4 percent inflation is costless. We
have not indexed contracts, the tax code,
or the legal system. And, most important,
the constraints on monetary policy that
would be needed to give people confidence
in a stable inflation rate have not
been implemented.

"Every $1 rise in the price of an apple means the buyer is $1 poorer and the seller is $1 richer."

If the sellers that benefit from inflation invest that extra $1 in a way inferior to how the buyers would have deployed it, then real income will decline.

Due to the way inventory and depreciation are accounted for, at higher rates of inflation, real corporate taxes increase and more resources flow from the private sector to government. If government is an inferior allocator of capital, then an inflation rate of 4% will result in lower real income than a 2% rate.

Alex: Suppose I argued like this: "Over the last 100 years, wages and incomes in Canada have increased faster than prices. Therefore inflation has increased real wages, and real incomes. Therefore inflation is a good thing."

Nobody would, or should take that argument seriously.

Lorenzo from Oz:
"Jacques René Giguère: The '70's were not inflationary. They were contractionary They were a time of real shock ( oil) and subsequent fall in real wages. Spending continually outpaced output at a considerable, if variable, rate. That led to considerable and continuing rises in the price level: to most people, that's inflation. "
Nominal spending could go up because of accomodative monetary policies. Even real spending could go up because it was botth a period of strong technological progress and incresed high-quality labor from the baby-boom and push for education from both GI Bill and National Education Act following the Sputnik scare( and corresponding actions in other western countries.) Those real effect compensated for the real shock. And the monetary stimulation on an overall relativaly stagnant did produce inflation. Which everybody confused with the source of their stagnant living standard , peak oil.
Confusing cause ans effect is a basic feature of the human mind.

Here's a list of good (i.e. not obviously bad) arguments against *long run* inflation *caused by monetary policy*. Straight out of the textbook:
1. Shoe-leather. It's a tax on holding currency that has all the normal deadweight costs associated with any distorting tax.
2. Menu costs. You have to print new menus more often.
3. Menu cost/relative price distortions. If you don't print menus more often, relative prices fluctuate for no good reason.
4. It's hard to index the tax system (God knows why, but it seems to be).
5. It's harder to remember when you last saw a price, so you can tell if the current price is a good deal or not.
6. It confuses accountants and other ordinary people.
7. Poorer people hold a bigger percentage of their wealth in cash, so the inflation tax hits them relatively more.

Here's a list of good long run reasons why monetary policy-caused inflation is good:
1. It avoids the ZLB on nominal interest rates.
2. It avoids the ZLB on nominal wage changes.
3. It's a good way to tax criminals who use cash.
4. It's a tax with low collection costs.
5. It's expensive to print banknotes, so the users should pay.
6. ?

Then there are lots of good *short run* arguments why *changes* (variability) in the rate of inflation may be bad:
1. Unfairly (and inefficiently?) redistributes wealth between creditors and debtors. (The "short run" here could be a very long time, since there are lots of 30 year nominal bonds and pensions, etc.)
2. If some prices are stickier than others, it screws up relative prices.
3. It *may* cause inefficient fluctuations in output and employment.
4. People use "rules of thumb" that seem to work in practice that tell them (for example) how big a mortgage they can afford. A change in inflation and nominal interest rates means the old rules of thumb don't work properly any more, and it takes ages to learn new ones.

And then there are really bad arguments. Like the inflation fallacy.

Spam filter ate my comment, and Jeff's. I retrieved both.

So if your comment doesn't show up, don't panic. I will check periodically. We very rarely delete comments.

Nick Rowe: "Most of us earn our income from selling our labour."
Old Ari: "But I don't have anything to sell, I buy with money I have saved"

There's something about labour, and the value of time, that take a while for people to wrap their heads around. Nobody seems to see themselves as "selling" labour before learning economics in an academic setting.

My guess is that the inflation fallacy is related to why every public policy seems to need to be phrased in "jobs" for it to get any political traction. [insert Stephen Gordon rant here]

I recall having a discussion about prices which led to me talking about market clearing through queuing, and someone else flat out refused the idea. It's as if because if I waste time in a queue, there's no obvious gains from my use of time this way (except for lower than market clearing priced goods, which seems to be forgotten), so it doesn't count as a cost because it's not "paid" to anyone else.

Nick: "monetary policy-caused inflation"

Hey! You didn't say that! You said "inflation"! I feel tricked. What exactly *do* you ask your students?

Anyways. Made me think about how stupid it is to define inflation relative to a basket of goods that a typical wage earner can afford (and not include e.g. the price of the right to name an elite business school). What a scam!

From Reuters "Disastrous" bond sale shakes confidence in Germany

The German debt agency was forced to retain almost half of a sale of 6 billion euros due to a shortage of bids by investors. The result pushed the cost of borrowing over 10 years for the bloc's paymaster above those for the United States for the first time since October.

The move in yields is small (~10 basis points) but are German Bunds about to get risky?

For example, why are you assuming that changes in consumer prices and changes in wages are unrelated?

I'm certainly not doing anything of the sort. I'm assuming that they are related *through the wage bargaining process*, which is an utterly unremarkable observation that pretty much every economic policymaker and literally every wage bargainer uses as an operational decision rule. Whenever anyone talks about a wage-price spiral, wage restraint, a tight labour market being an indicator of inflation, etc, they are asserting this. Similarly, whenever anyone talks about setting expectations of low inflation, they are asserting this. Central bankers quite often explicitly say that they want to set wage bargainers' expectations of inflation!

I mean, how else do we get from higher prices of goods to higher wages? There has to be a mechanism of action, a microfoundation for the macrophenomenon.

Change the wage bargaining process, and the effects of a given amount of inflation (or indeed deflation) will be distributed differently. And because wages are by far the biggest source of demand, this has consequences for GDP.


In a previous post, I got on my hobby-horse and said there was more than one kind of recession. Jacques agreed with me and in order to be clear about what exactly we are talking about, we defined the following terms:

Recession: A demand-side phenomenon in which the supply of money falls. An economy is choked by the lack of money. I was at a breakfast discussion with Torben Drewes of Trent University in early 2009 where he gave a brief overview of the current Crisis and his first point was that the broad money supply had taken a nosedive.

Contraction: A supply-side problem where the production possibilities frontier of an economy shrinks due to loss of some supply. Oil is the poster child for what can cause this because it is our main fuel for transportation and our main feedstock for carbon-chemistry derived products, plastics, synthetic oils and polymers of all kinds. It is embedded in our economy like nothing else.

A contraction is a supply problem and a recession is a demand problem. Both are economic problems and both lead to a fall in wealth, production and standards of living but the suite of appropriate tools to solve them is very different between the two.

I have a little soapbox here and a gong where I bang away saying there is more than one kind of recession.

Nick of course doesn't believe in general supply-side contractions but admits he's radical in this regard.

Glad that was cleared up--now all those Germans from 1918-1935 know how foolish they were to worry about inflation. I guess their only concern should have been the size of their wheelbarrows?

Inflation is a silent and stealthy thief that robs from the prudent and those who are willing to postpone consumption. It ruins pensioners and those on fixed incomes. Because inflation breeds inflation it is like playing with fire.

This paper has a glaring fallacy in that it doesn't matter what a company's gross revenue is, it is the net income that is important. Inflation makes predicting net income very uncertain if not impossible. Uncertainty . Some select companies or individuals may benefit but the majority do not.

If you can name one country that was benefited by sustained inflation that might make this argument stronger. Surely through all of history you could find an example of a country that could see through the "inflation fallacy"--if that is indeed what it is.

If inflation is neither good nor bad then it shouldn't matter if there is inflation or not, so let's not have inflation.

Whether an increase in price(s) is good or bad depends on the case. If there is a general increase in prices as a result of a fall in production, then this is just part of the market mechanism dealing with a supply problem. That's "good inflation". If there is a general increase in prices as a result of excess money growth, then that's sending false prices signals throughout the economy. That's "bad inflation".

(Compare with good deflation and bad deflation: the former is the price mechanism responding to a general increase in productivity. The latter is a distortion of the price mechanism as a result of deficient money growth.)

The inflation fallacy, which does indeed form part of a lot of thinking about inflation, fails to look at the causes and therefore leads people astray. Recognising that the inflation fallacy is a fallacy has nothing to do with thinking that inflation is good or neutral.

It is SAVINGS not income. Inflation reduces the value of all savings and investments. It encourages the reduction of savings and investment leading to a drop in production, which in turn leads to a drop in employment.

It didn't work for the Qing emperor and it won't for us.

The students' answer, "Because if all prices rise 10% we will only be able to afford to buy 10% less stuff. Duh!" is not as bad as the writer makes it sound. It is true as far as spending saved dollars goes. It's also true if the prices of the goods and individual buys rise faster than his wages.

The Austrians (such as Mises) demonstrate why inflation is never a simple x % across-the-board increase in prices. People who receive the newly-created money sooner will bid up prices for the goods they buy before other prices are affected. For example, if new money goes first to wealthy bankers, you will see prices rise at the Louis Vuitton store before they rise at Big Lots. There is no reason they will eventually even rise by the same amount. In the real world there is simply no situation where everyone wakes up one morning to find their money has simultaneously increased by the same amount.

Wage increases tend to lag behind consumer price increases because employers do not feel pressure to raise wages until after their employees see price increases in the goods they buy. They may not even rise to fully keep pace with the increase in prices of the consumer goods. Indeed, centrally-planned inflation is often carried out specifically as a means of lowering real wages.

Whether inflation benefits or harms an individual depends on whether their buying prices rise slower or faster than their selling prices, and by what amount. It also depends on how much wealth the person has kept in the inflated currency. But there are certainly cases where a 10% price increase can lead to a 10% decrease in an individual's purchasing power.

"4. It's hard to index the tax system (God knows why, but it seems to be)."
Because most of the times we think as "inflationnary" are contractionnary ( mine and Determinant hobby horse if you will) and so real tax revenues fall. A good way to keep what you need to keep gunmint going is not to index tax forms. Otherwhise, we can go the german 1923 route and monetize all G expenditures. Then you get hyperinflation. Only then.


Grrr, this is a pet peeve of mine.

Germany decided to finance WWI out of borrowing, not by levying an income tax as France and the UK did. Thus they had very, very large war debt. Then they had to pay reparations in gold. So they inflated away their own war debt and tried to get gold by hook or crook.

Belgium and France occupied the Ruhr (Cologne and area) in 1923 to ensure payment of reparations in goods, not now inflated and nearly worthless marks. The occupation caused a general strike in the Ruhr and the German government paid to workers to say on strike. In order to pay for this they printed yet more money.

All of this stabilized in 1924 when Germany moved to a new Rentenmark and the old Reichsmark was repudiated. The first round of Reparation restructuring also began at this time.

Hyperinflation was OVER by 1924. By 1933 it was 9 years in the past. Hyperinflation did not lead to Hitler in the way that is popularly believed. Weimar Germany in fact prospered in the 1920's. The ruin of the German economy after 1930 was a separate and distinct crisis.

Of interest, Germany's WWI reparations were restructured in 1935 by the Lausanne Conference and rolled into a bond series. After WWII they were suspended but not forgiven. The principal was repayable but the interest was suspended until Germany reunified. That happened in 1991 with the "Treaty of Final Settlement with Respect to Germany", the anticipated final peace treaty, was put into effect. Germany resumed payments on the reparation bonds. The final bonds were paid off in full in 2010, at which time we finally closed the books on WWI.

Inflation is only bad if you aren't stocked up on inventory and it hits.

I've sold structural steel for the last 12 years. When we have deep inventories and the price of steel jumps we make more profit. 10% markup on 100 dollars of steel = 10 dollars in my pocket. 10 % on 200 = 20 dollars and so on.

What sucks is when the price of steel drops and you are sitting on steel bought at 50 cents a pound and your competitor is empty and gets to buy at the new low mill price of 45 cents per pound and now you have to sell your steel at 48 cents per pound. Thats when stuff gets nasty.


A very good perspective. I wish economists would take more about inventories when analysing business cycles. Ceteris paribus, an anticipated fall in input prices means "don't buy now" and an anticipated rise in input prices means "buy now".

(Of course, that can't be true, because we all know that the economy is like a hydraulic machine and people don't act on the basis of forward-looking expectations; otherwise it would be possible for a policy to have effects simply because it had been announced. [/bitter sarcasm])

Perfectly right on german WWi financing.
It would have worked if
1) they had won and exacted tribute or
2) at least they had done what the Allied did in WWII and borrowed from their workers the pay they had just received. But they monetized first and then paid the workers. Inflation had started during the war as you noted.
In WWII , Hitler "simplified" matters in his usual management style. He refused to mobilize women plundered either directly (the Easte)or through "occupation taxes (France)and avoided paying the workforce by taking slaves,including domestic ones(no wonder you were happy with the regime if it meant your own Ukrainian peasant girl in the kitchen...The average germans knew a lot...)


I'll second Jacques compliments on your German WWI financing. But more about Hitler's rise -- in response to the start of the Great Depression, German Minister of Finance Burning clung to the Gold Standard and balanced his nation's budget, leading to a 30% drop in price level by 1933. It was this grinding deflation (and resultant high unemployment) which set the stage for the Nazi's election.

In contrast, the U.K. left the Gold Standard in 1931, after which her unemployment and industrial output stabilized (see these recent summaries).

One could argue that the UK's actions in abandoning the Gold Standard in 1931 are an excellent example of the benefits of inflation.

You sir, should not be teaching economics.
What a very simplistic explanation of inflation. Its so nice to be schooled by a real "economist", of the same sort that is literally burying Europe and North America into an economic collapse probably never seen before.
Of course most people referring to "inflation" are referring to an increase in money supply, not some harvest drought! Thus it is so commonly referred to "printing money." Wise up man!
You seem to completely ignore the issue of the velocity of money and seem to think that when the supply increases everyone has it at exactly the same time.
So, what is so bad about inflation? How about it destroys people's life savings... especially when there are interest rates held at near 0 percent. If there is no effect of inflation, why has the price of every single commodity, even those completely unrelated, rather it be gold, silver, corn, oil risen between like 200%-1000%?
Inflation is nothing more than an attempt by countries to devalue their debt because they are about to implode under its weight. By doing this they completely destroy the wealth of people who have saved (how about retirees who have saved their whole life and have their money wrapped up in the 'safety' of govt bonds returning 2%).
You seem to be just another bitter economist that is coming to the realization that they have committed their life to learning an economics system that is becoming completely discredited before their eyes and can't accept this reality. Sort of like the people getting "green degrees" and can't find a job, it's hard to admit that your entire skill set is worthless.
I think when I was like 10 years old I remember asking my parents "why 'they' didn't just print more money so everyone can be rich". Unfortunately today's "economist" is peddling an economic theory that would be absurd to a more intelligent 10 year old.

IIRC, Kaldor attributed the fall in UK unemployment to the adoption of tariffs by the National Government, rather than to leaving the Gold Standard. This left him in a bit of a crisis: did that mean that Neville Chamberlain was a good chancellor? Apparently he never quite could answer that question.

I'm fascinated by the idea that the UK's economic policy under the National Government (fiscal austerity offset by a loose monetary policy) could get some credit. The classic view, which comes mainly from Keynes, is that the UK's problems in the 1930s were demand-side rather than supply-side. Though NGDP statistics say otherwise, the idea was that the 1930s were a period of low demand and this caused high unemployment during the decade. Hence anyone who proposes cutting the deficit in a period of sub-trend growth is accused of wanting to go back to the economics of the 1930s.

Interestingly, this myth of 1931-1939* as a period of disastrous demand-side policy in the UK led to the Keynesian revolution and has therefore shaped modern economics:


* Some British history textbooks now attribute the recovery to increased armaments spending from 1936 onwards. I have heard many things said of fiscal policy, but I never knew it could cause a reduction in unemployment that occured five years previously!

GA: "I'm surprised no-one here has put this in a simple behavioural / availability / Kahneman-Tversky framework."

GA might be onto something. (Though it's something I don't pretend to understand much.)

Dr Why: "Inflation has well known costs and benefits and a 2% inflation target simply represents the existing consensus on the best trade-off between those costs and benefits."

Yep. That's roughly my position. Plus, 2% is the rate that Canada has gotten used to, so any change in the inflation target would mean variation in inflation.

Alex: "Because clearly, if the empirical observation [that UK real salaries fell in the last year] disagrees with our axiomatic principles, the observation must be wrong."

I wrote this post for Alex. At least, I wrote this post for Alex and all the millions of people like Alex. Clearly, I have failed miserably. Alex wonders if I think that it is theoretically impossible for real wages ever to change.!!!!! I wonder how many times I have drawn a diagram with real wages on the vertical axis, shifting curves around, showing why real wages might change. I wonder how many times I have played around with different theories of sticky prices and/or sticky wages showing how even monetary policy might have short run effects (in either direction) on real wages.

Suppose Alex were right, in arguing that since real wages = W/P, then a monetary policy that caused higher inflation would increase P and therefore reduce W/P and make people worse off. What policy conclusion would I draw? I would recommend an extremely tight monetary policy, to create massive deflation, and a massive fall in P, which would, mathematically, increase W/P and make people very very rich. Oh God.

I really did try in this post. Clearly I have failed miserably.

Thanks to all those who liked the post, and those who gave good arguments on the costs and benefits of inflation.

But the one thing I have learned, especially from the sheer number of comments on what was really a very boring post on what should be a totally uncontroversial point (the inflation fallacy is a bad argument against inflation, though there might be other good arguments for or against inflation), is that the subject of inflation really arouses passions. And that the inflation fallacy (as well as conceptual confusion about inflation) is really deeply entrenched.

Plus, I used to think that the inflation fallacy was more of a righty meme. Now I've learned that lefties are sometimes equally susceptible.

I had to take two electives in First Year university; one was European History from the French Revolution to 1945. We did the 19th Century and WWI in spades. C'mon, this is economics blog, we believe in getting value for money!

The Depression was a separate disaster in Germany and I thank you for your point about the Gold Standard, Kosta

People forget that the Weimar Republic was doing OK economically by the late 1920's. Germans seemed to settle in to democracy and things actually worked, if only for a while. Hyperinflation was in the past and the German economy got over it soon enough.

But hyperinflation and then a toruous deflation combined with bitterness over reparations led to disaster.

To get back to Jacques' point, we really have to remember that the days prior to 1914 were a different world. This is a wonderful website to remind of the economic contradictions of the era: http://www.loc.gov/exhibits/empire/work.html These are colour photographs (using composite process; researchers recently put them together) of Tsarist Russia. This is a world, in colour, that truly is no more. Notice how you have camel drivers and peasants whose lives haven't changed in centuries next to electrical generators from Hungary.

It was an era of unbridled capitalism (see the Singer Sewing Machine office in St. Petersburg, Russia), low taxes, small government and expansive empires. People didn't think the way they do today. It was also the time where the government had to face up to poverty too, the health of Army volunteers from inner London was deplorable and it was common for them to put on weight in basic training simply through having more calories.

I have one great-great grandfather who immigrated to Canada from England in 1912 to escape the new Income Tax after the People's Budget. Canada advertised itself heavily as having no income tax. In 1914 nobody had any clue what the real costs of running a mass conscript army with the capability and expenses of industrial warfare were.

Austria-Hungary never figured it out, they were a complete basketcase in terms of war organization which wasn't helped by the fact that their government arrangements were also a basketcase. Russia decided to pay in men instead of material and suffered disaster after disaster at the hands of the better-equipped German army. For the first time material and organization mattered more than men and you couldn't simply swamp an enemy with conscripts anymore.

Germany almost figured it out by the German imperial government wasn't a real democracy, the Reichstag was a sham. There was little financial capability and even more importantly little way to procure popular consent to wartime taxes.

It was France and Britain who barely figured it out in time. The British had a shell shortage crisis in 1915 but managed to have fully functional industrial mobilization and excellent financial arrangements by 1917. France had the same thing roughly.

And finally to follow on from Jacques point about WWII, the UK was much, much better organized than Germany ever was. It was Britain who had the more pervasive and effective command economy. Bevin boys in coal mines, effective rationing with substantial compliance, mobilization of women to do almost everything, industry that was robust and able to make up losses easily. Plus finanacial arranagments that worked, including Lend-Lease and Mutual Aid in Canada's case.

Britain reached its full economic potential in WWII, Germany wasted their potential.

I think it is the division of those who think inflation is bad for themselves and those who think it is good for themselves, regardless of whether it is good or bad for the whole, the focus on narrow self interest, and that it is easier for most to see the bad than the good that leads to such beliefs. If they don't see it in their personal interest, they refuse to see it in anyones, or if they do, have motive to reject it anyway. This is why greed is good was so popular.

W. Peden raised the interesting topic of inter-war British economic policy, which is very relevant today.

Britain had 6% unemployment in 1914 and was on the Gold Standard. Per normal practice for Really Big Wars the Gold Standard was suspended during the war.

In 1918 it was government policy to return Britain to it's pre-war condition as soon as possible. Back to 6% unemployment as all those peace-time jobs returned and everyone settled back into what they were doing in 1914. And of course back to the sound policy of the Gold Standard.

Demobilized soldiers were given an "Out of Work Donation Policy", one of the the first Unemployment Insurance policies of its kind, payable for one year. It was to help soldiers get back to their pre-war routines.

But things never returned to the prewar routine. In fact the UK developed stubbornly high unemployment in the 1920's. It never got below 8%. Those Donation Policies had to extended repeatedly. Their experience was exactly the same as what the United States is experiencing right now. Stubbornly high unemployment, lack of job creation and the need to extend benefits repeatedly.

Britain didn't break the 6% unemployment barrier in peacetime until 1945. Full employment did not return to the UK until the late 1940's and early 1950's. That's the conundrum of interwar economic policy. What happened to the jobs?

Yes, I know hell or high water policy of returning to the prewar Gold Standard was part of it, but the question remains.

I still don't get it. When you ask your students why inflation is a bad thing, why is it that they are supposed to answer from the perspective of the representative agent rather than say from the perspective of the representative wage earner? Or median wage earner? Or student? Depending how you define and chain your consumption basket (it's not easy) they may be getting poorer. In the future robots may make them extremely poor through a process which, with a bit of help from monetary expansion, will appear as price inflation (to avoid wage deflation). Maybe they've already sensed the beginning of this process. They are certainly getting relatively poorer. I just don't see the relevance of income=expenditure for the vast majority of the population. Why is wrong for them to forget about the capitalist?

Nick: it's been a toy theory of mine for a decade or so that inflation may 'need' to be higher for a period in economies that 'need' to reset relative prices (meaning that 'prices' had been set arbitrarily at the starting point, or if you prefer, that prices have been subjected to a dramatic external shock). The origin of this idea is spending a lot of time in former Communist (or whichever term you prefer) economies.

Basically, assume prices at the starting point are completely arbitrary, and that wages at that same point have been calibrated to permit purchases of an acceptable basket of goods. The price mechanism is not the sole or primary means of allocation of goods (i.e. there are things like quotas and coupons for certain goods, or queuing, or whatever). (I'm going to ignore monetary overhang of savings which can't be spent because there aren't sufficient goods available - which, when prices are freed, would just result in a brief, one-off superinflation - in other words I'm arbitrarily going to ignore monetary policy to start).

Prices are freed at the starting point. Information and other frictions abound. Supply response is not instantaneous. Some prices are still regulated and/or provided by government monopolies, which may not be allowed to raise/change prices at will. Price discovery has to be iterative.

I think only one condition has to be true to make it clear that this economy 'needs' higher inflation to allow relative prices to adjust (somewhat) more efficiently. That condition is that for whatever reason, all sellers of goods, services, labour exhibit much greater reluctance to lower their prices than to raise them (directional stickiness, which could be seen as a form of loss aversion).

I'm not the mathhead to build the model for this, but the conclusions to me are obvious. Inflation 'needs' to be higher than in countries that start with a non-arbitrary dispersion of prices and a functioning price mechanism.

Relax a few assumptions but keep the central one (reluctance to lower prices, or stickiness) and even price stability (in the zero percent inflation sense) would also be seen as problematic. (This is without interaction with the financial sector, asset inflation, etc). May be one gut sense for why the Blanchard inflation target makes more sense. In fact, the arbitrary condition is an extreme but ultimately not that special case.

We can say that acclerating and very high inflation is 'bad', but the positives of price stability quickly disappear if one realises that there is no such thing. Price formation and adjustment is a process by which relative prices change - and any impediments to adjustment throw the assumptions about the benefits of price stability out the window. They're not stable - they're moving around a central tendency.

And monetary policy may need to accommodate this adjustment process.

(And before the objections start, I'm not arguing for aribtrarily huge,unlimited inflation - but perhaps 5% inflation is 'too low' for Russia for some time until prices have done the bulk of their adjustments.)

K: Suppose someone said that an increase in inflation would change the distribution of income, because wages were stickier than prices, so that real wages would fall, so labour's share of income would fall, even if total income stayed the same.

Anyone who made that argument would not be guilty of the inflation fallacy. It's a totally different argument. Given the assumptions (wages slower to adjust than prices) it makes sense. Many macroeconomists (arguably Keynes) have made this same argument.

The argument is usually made in reverse. Starting at "full employment", a fall in AD will cause prices to fall, but wages will stay the same in the short run by assumption, so real wages will rise, and employment will fall. Because employment falls, real output will fall, and real income (which is the same as real output) will fall too. Real wages per hour rise, but total real wage income may either rise or fall, depending on the elasticity of labour demand.

Empirically, however, this argument doesn't seem to work very well. Soon after Keynes' General Theory was published, econometricians started looking to test it, to see if real wages were countercyclical as this theory predicted (rising in recessions, falling in booms). And they didn't seem to be.

My (cursory) reading of this empirical literature is that it's hard to find strong empirical evidence of either counter-cyclical or pro-cyclical real wages. The results seem to be rather sensitive to how exactly you measure things. So New Keynesian macroeconomists abandoned the assumption that wages were slower to adjust than prices. (Most New Keynesian models actually make the exact opposite assumption, but that's only for analytical convenience, since it makes little difference in NK models). My working assumption is that wages and prices are roughly equally sticky. But I wouldn't go to the wall to defend that assumption.

"Why is wrong for them to forget about the capitalist?"

1. Because capitalists are people too.
2. Because retired pensioners are capitalists.

GA: most/many(?) macroeconomists believe some version of your argument. It's normally slightly restated by assuming it is money wages that are sticky downwards, and there is empirical evidence to support this. If you look at a frequency distribution of nominal wage changes, there's a big spike at 0%, and a sort of gap in the distribution just below 0%. And the usual estimate is that something like 2% inflation is enough to avoid most of the problems this zero lower bound on wage changes could cause.

Matt: "You sir, should not be teaching economics."

You know, if you would open your mind, Nick could teach you some economics, too. :)

Excellent. And I can think of good reasons for the reluctance to lower prices.

1. Uncertainty - if buyers arrive in a Poisson distribution - a period without a sale may just be bad luck.
2. Expectations - if buyers see prices falling they may wait in the hope that they will fall further.

Tip: if you see analyses of economic change that are missing those two words don't believe them.

"Clearly, I have failed miserably."

I sympathise, inflation phobes are very persistant (those pots of money under the mattress must be more common than I thought). I put it this way - I lives through the seventies. My parents lived through the thirties and I'm alive today (although where I am it is not so bad - yet). The seventies were not so bad. Discuss.

Old Ari
"But I don't have anything to sell, I buy with money I have saved, if you reduce the value of my savings, more and more my savings are being stolen."

When did you save the money and what was the inflation rate then? And why didn't you buy bonds which pay positive real interest rates - coming due when you are ready to consume? And did you invest your savings in productive assets that would insure that the goods you wanted to consume later would actually be produced? This comes to heart of the question - what is money for?

Suppose someone said that an increase in inflation would change the distribution of income, because wages were stickier than prices, so that real wages would fall, so labour's share of income would fall, even if total income stayed the same.

This is, in fact, my argument. In a political economy heavily biased towards capital, it's easier to put up the price of goods than it is to put up the price of labour. Therefore, if you decide to deliberately inflate the economy, which of these two actors will benefit? As I pointed out again, and again, and again, if you call the two actors "debtors" and "creditors" nobody would be surprised for a moment that inflation has different impacts on them!

In a recessionary environment, where investment is low (which is observable empirically), I expect this to reduce aggregate demand because the corporate sector will save the difference (and we observe this empirically - firms are stuffed with liquidity) and - obviously - workers will have to cut back (which is also observable).

If you say "We want full indexation and if we don't get it, not a single wheel will turn" and get it, then there will be a nice stable NGDP growth path and an inflationary settlement of the debts from the Great Bubble. If you say "I want full indexation" and they say "You're fired", there...won't.


Perhaps the return to the Gold Standard was less important in the long run than the rise in the real value of benefits in the 1920s.

In other words, the demand-side explanation explains a lot of the cyclical unemployment and the classical explanation explains why the unemployment turned into persistent structural unemployment that took about two decades (and a huge reduction in real wages/benefits) to eliminate.


What would you call it if CPI rises by 5% per year but wages only rise by 2%? I'd say wage earners are getting killed by inflation. I suspect your students would too.  Of course, it's not the kind of inflation monetary policy can do anything about. It doesn't matter if it's 5 and 2 or 3 and 0. It might occur due to a loss of bargaining power versus foreign labour and robots.

And the idea that we are all the capitalist is just silly. The vast majority of the population are poorer than average throughout their lives. If all the capital was in the hands of one person would you still be happy with your argument? Should we all just feel happy for that person? When does it become absurd?

Alex: somewhere, deep in your mind, there's some sort of macroeconomic model. But for the life of me I can't figure out what it is. (Forget for a minute whether it's right or wrong).

First off, by standard conventions of national income accounting, real output = real income. And real output is an increasing function of employment, for the obvious reason that the more people you have working (given technology and capital stock) the more output=income gets produced.

Get a bit of paper. Draw axes of a graph. Put P (the price level) on the vertical axis. Put Y (for real output = real income = roughly speaking employment) on the horizontal axis.

Now, assume we are in the short run, so that W (the nominal wage per hour) is fixed. Assume P is perfectly flexible, for simplicity.

I want two curves.

The standard macroeconomic model with these assumptions looks like this: There's an upward-sloping Short Run Aggregate Supply curve (a 10% exogenous increase in W shifts that SRAS curve vertically up). There's a downward-sloping Aggregate Demand curve. A loosening of monetary policy (bigger money supply, lower interest rates, whatever) shifts that AD curve up and to the right. In that standard model, if you want to increase real output, real income, and employment, you loosen monetary policy to shift the AD curve right. A side-effect of loosening monetary policy and increasing Y is that P rises (if the SRAS curve slopes up). This causes a fall in W/P (real wages per hour). But total real wage income (W/P times person-hours of employment) will usually increase (unless the SRAS curve is very steep, so that P rises by a greater percentage than employment).

Now, I don't really believe that model, because W/P is not, empirically, negatively correlated with employment over the business cycle. But never mind that.

How does your model differ (if at all) from that standard textbook model? Does your SRAS curve slope down? Does your AD curve slope up? Are you arguing that the Bank of England should tighten monetary policy (reduce the money supply/raise interest rates) to create deflation in order to increase real wages, AD, output and employment? Or what? Is there actually an internally consistent model underlying your words, and what is it?

K: "What would you call it if CPI rises by 5% per year but wages only rise by 2%? I'd say wage earners are getting killed by inflation. I suspect your students would too. Of course, it's not the kind of inflation monetary policy can do anything about. It doesn't matter if it's 5 and 2 or 3 and 0. It might occur due to a loss of bargaining power versus foreign labour and robots."

I call that "falling real wages due to loss of bargaining power as a result of foreign competition and robots". And if that is indeed the case, and it is indeed something that monetary policy can do nothing about, then it is not caused by an inflationary monetary policy. By assumption.

reason: "I put it this way - I lives through the seventies. My parents lived through the thirties and I'm alive today (although where I am it is not so bad - yet). The seventies were not so bad. Discuss."

My father, who lived through both the Great Depression and the Stagflation, told me, "Inflation is bad, but deflation is worse."

K: "And the idea that we are all the capitalist is just silly."

What does a capitalist look like? Someone like me. Depending on when I retire, my future wage income is probably worth less than my pension plan, house, and savings. So I'm probably more of a capitalist than a worker, from this point on. Do I not bleed when you cut me? First they came for the 1%, and I said nothing, because I was not one of the 1%.....then I found I was one of the remaining 1%. You are talking to someone who is "the other". We look just like you "regular folk".

Alex: "In a political economy heavily biased towards capital, it's easier to put up the price of goods than it is to put up the price of labour. Therefore, if you decide to deliberately inflate the economy, which of these two actors will benefit? As I pointed out again, and again, and again, if you call the two actors "debtors" and "creditors" nobody would be surprised for a moment that inflation has different impacts on them!"

Let me risk dipping my toe into this. First, you are calling the capitalists debtors and the workers creditors, right? At first blush that sounds counterintuitive, since, aside from the employment situation, it is likely to be the other way around. But the capitalists do have an obligation to pay the workers.

Second, I am uncomfortable with the phrase, "deliberately inflate the economy." First, at least in the U. S., I am not sure that we can talk about **the** economy. On its face, there appear to be two tiers to the economy. The top tier has recovered from the recession, the bottom tier has not. Policy makers focus on the top tier, and so the recession officially ended a couple of years ago. Sometimes I wonder if the best hope for the bottom tier is if the top tier goes back into recession.

Second second, "inflate" the economy is vague. ("Inflation" is vague, which is part of the problem with this discussion. ;)) Doesn't who benefits depend upon how we inflate the economy? If we give money to bankers, that's one thing, if we give it to paupers, that's another, no?

Are you arguing that the Bank of England should tighten monetary policy (reduce the money supply/raise interest rates) to create deflation in order to increase real wages, AD, output and employment?

I'm arguing that having it create inflation in order to fight the recession (or the lesser depression...) is not a sufficient condition of recovery, although it's probably a necessary one. That the distributional impact of the inflation, if wage-bargaining is really weak, could be enough to outweigh the shift in the AD curve (or shift it back).

I'm not sure if I'd call it a shift or a skew in the curve, but essentially what's happening is that additional nominal income is going preferentially to actors with a higher propensity to save, so the elasticity of Y with respect to P is changing.

Alex: Let's break this into two parts:

1. Suppose I built a model in which wages are determined by the relative bargaining power of workers and firms. Lots of economists build models like that. But, unless I put something else into the model, that still gives me a model in which real wages are independent of monetary policy and inflation. Workers and firms care about real wages, not money wages, so relative bargaining power determined equilibrium real wages, not money wages. Real wages in that model will (usually) be lower if workers' bargaining power is weak, but real wages won't be affected by monetary policy. You need *sticky* wages (or sticky prices, or money illusion, or something) to get real wages depending on monetary policy. Weak bargaining power alone won't do it.

2. Forget bargaining power, because it doesn't give you the sticky money wages you need to make your argument work. Let's just assume that money wages are sticky, for some unknown reason. And let's take a standard Keynesian (ISLM) theory of the AD curve, but modify it by assuming that the marginal propensity to consume out of wage income is greater than the mpc out of non-wage income. That modification will tend to make the AD curve flatter. (The reason is that a rise in P, for given W, and given Y, changes the distribution of income away from workers and so reduces consumption demand, and hence reduces aggregate demand). But in that model your conclusions still do not follow from your assumptions. A looser monetary policy will shift the AD curve right, and it will increase output, the price level, real income, employment, and increase real wage income, even though it reduces real wages *per hour* (W/P). To get your intuition straight on this you need to carefully distinguish between real wages per hour, and real wage income (=(W/P) times employment). Consumption (in your model) depends on real wage income, rather than real wages.

i (not an economist) always thought that the reason "inflation" (as in an expectably nominally larger economy over time) is good is to avoid artificial rigidities that occur around sticky prices. menu costs go up, and that's annoying, but that's the downside.

A further thought, Alex. Macro is hard. I like to think I'm quite good at converting verbal reasoning into graphs and vice versa and seeing if it really makes sense. But when I did the first draft of my comment above, I screwed it up.(I had your mpc assumption making the AD curve steeper, rather than flatter.) Fortunately I realised this just before I posted it, and fixed my mistake.

We are talking about a simultaneous system where everything depends on everything else. And words sometimes just don't do the job.

Now, if I played around with your model, I could even make the AD curve very flat, and flatter than the SRAS curve. Which would give really weird results, because (I think) you would actually have to tighten monetary policy (reduce the money supply) to increase output and employment in that model. And that model would actually make your verbal reasoning correct. Except, that model has an unstable equilibrium, so none of those weird results make any sense at all. Because we wouldn't get to the new equilibrium.

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