I’ve been bothered for years by my inability to understand just why inflation is bad. You’re now going to say, “it’s easy you dunce, inflation reduces your purchasing power!!”
But that’s not quite true – in aggregate, that simply doesn’t happen. In accounting terms, income always equals consumption and savings. There’s an element of wealth and income transfer involved between individual agents certainly, but add it all up and inflation only raises the money value of both sides of that equality.
But this post from Nick Rowe of WCI explains the whole thing in laymen’s terms (excerpt):
Sometimes I despair. Sometimes I wonder if the inflation fallacy is at the root of all the US and Eurozone troubles. 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. So it's much better to have high unemployment, low employment, low real output, and errrr, low real income, than to risk having low real income.
The inflation fallacy is an invalid argument about why inflation is bad. Now, an invalid argument can sometimes have a true conclusion. Maybe inflation is bad. Maybe inflation does reduce our real incomes. But it's still an invalid argument. It doesn't give any good reason for thinking that inflation is bad, or reduces our real incomes.
A lot of non-economists believe the inflation fallacy. I'm an expert on what non-economists think about economics. That's because I have spent the last 30 years trying to teach non-economists how to think about economics…
…You could try to counter the inflation fallacy by talking about the neutrality of money. But that's the wrong approach. Sure, if money is neutral, and so has no effect on real variables like real income, then the conclusion of the inflation fallacy would be false. But that misses the point. The inflation fallacy is an invalid argument. It is logically, conceptually, confused. Even if the conclusion were true, it would still be an invalid argument. Even if inflation did cause falling real incomes, the inflation fallacy would not be a good argument for believing that inflation would cause falling real incomes.
Why is the inflation fallacy a fallacy?
Apples bought must equal apples sold. What is an expenditure to the buyer of apples is a source of income to the seller of apples. Every $1 rise in the price of an apple means the buyer is $1 poorer and the seller is $1 richer. That's true whether we buy and sell one apple or buy and sell one billion apples. It's true whether or not we add in bananas, carrots, dates, and eggs. It's true whether all prices go up by the same amount, or percentage, or if they all go up by different amounts. It's true whether we measure prices in money, in gold, or in venus dust…
The comments in this blog post are also worth a close read.
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he missed one very crucial point.
ReplyDeleteInflation has time factor. Make it short, who get the money first win!
another Keynesian myths.
ReplyDeleteThanks Hishamh! As you can see from the comments, a lot of people got upset by my post.
ReplyDelete@anon 10.11
ReplyDeleteYes, that was mentioned in the comments. I did say that there was an element of transfer involved. But in aggregate it all still adds up.
@anon 10.13
Care to elaborate?
@Nick
Any time! Love your blog posts by the way. Keep at it.
Holy shit. That's Nick Rowe commenting on your blog!
ReplyDeleteLet me take a stab at a possible scenario. Let us assume that what Nick said is true (i.e. on aggregate, if a buyer is $1 poorer, a seller is $1 richer).
ReplyDeleteWe also assume that there are more buyers than sellers in the market. I agree I have no proof of this, but I think it is intuitive enough. Because I can claim that everyone is a consumer (aka buyer), but not everyone is a seller. If you allow this, let us consider the following.
For convenience, let us assume that the ratio between buyers and sellers is 10:1. This means that for every buyer who is $1 poorer, a seller is $10 richer. Assuming the law of diminishing marginal utility holds, the total utility lost by the 10 buyers is less than the total utility gained by the seller.
This is simple. Assume that initially $1 can buy 1 util for 1 buyer. As the seller becomes richer by collecting more $, the marginal utility for a gain in $ is lower. I guess you covered it when you mentioned that "There’s an element of wealth and income transfer involved between individual agents certainly, but add it all up and inflation only raises the money value of both sides of that equality."
But I think the "bad-ness" of inflation does not stop at real income. I argue that, while on aggregate, the real income in the economy did not change, but the aggregate utility has declined based on my argument above. Which means that on aggregate, the economy is "worse off" i.e. "badder".
Of course my argument rests heavily on the 2 assumptions:
1. There are more buyers than sellers
2. Law of diminishing marginal utility
I am also mixing micro and macro. If there is a gaping hole in what I am thinking, please let me know.
Thanks Hisham and Nick for the interesting point.
@Hafiz,
ReplyDeleteCool, innit?
I don't know what surprised me more, Nick commenting here, or Google for indexing this blogpost bare minutes after I posted it.
@The Main Streeter
ReplyDeleteI think you've hit on part of the reason and I can't find any big flaw in your reasoning. Maybe that redistribution of wealth and income is why inflation is bad because it increases income and wealth inequality, as the rich have more options to protect their wealth from inflation.
I can't be certain though.
And I'm not sure about the more buyers/less sellers assumption. After all, even those who are not sellers of goods are sellers of services (i.e. their labour). Labour tends to be singled out as unique, but its still another market among many.
Two important problems with your position :
ReplyDeleteA) Even if one accepts that there was a nominal fallacy, people are psychologically bound to nominal levels. Rising price are distressing even when income rise by the same amount, if only because people tend to think that they are paid more because they are better recognized, more productive etc... - I.e. something they control and deserve - whereas the price of the goods they buy is something that they don't control.
B) Anyway there is actually NO nominal fallacy because debt is set in nominal terms, not real terms. Therefore, inflation has an impact on the real economy because of the variation of debt inventories. Steve Keen is particularly vocal on this subject
@charles
ReplyDeleteRegarding situation A, you've just described the fallacy Nick was trying to explain - people think they're worse off even when they're not.
And situation B is one of the points I was thinking of in terms of the impact of inflation through income and wealth transfers - individual agents will win/lose depending on how well protected they are against inflation. But in aggregate, it's still just a redistribution of real income and not a drop in real income, which is the point of the piece.
Taking Mainstreeter's example a little further - Those of means (i.e. the rich) can protect themselves better against inflation than those less well off. In any society, the less well off outnumber the wealthy.
ReplyDeleteErgo, redistribution of real income to the hands of the few from the hands of the many translates to the general perception of less wealth.
While it may be true for a particular point of time that total real wealth in the economy has not decreased, doesn't this ignore the fact that modern economies are based on mass consumption?
If mass consumption is a significant economic driver, continued redistribution of real incomes from the many to the few should eventually lead to slower or negative growth.
So, is inflation bad? It depends on the circumstances and whose perspective. In some situations, a little inflation can be a good thing. Like most things there are no absolute answers.
However, at this point in time, I believe that the benefits of a persistent "controlled" inflation policy no longer outweighs the disbenefits.
@tanstaafl
ReplyDeleteWealth and income are two very different things. And the empirical evidence linking income inequality with economic growth is a little shaky.
"However, at this point in time, I believe that the benefits of a persistent "controlled" inflation policy no longer outweighs the disbenefits."
You've lost me - what disbenefits are those? This sounds like a completely separate issue.
Just another point to add on to the argument about the income inequality issue. While overall real income may be unchanged, the propensity to consume is different across income groups. High income earners have a higher propensity to save, while low income earners have a higher propensity to consume.
ReplyDeleteBy that virtue, any change in price level is bound to affect people with a higher proportion of income spent on consumption more. And since it is a given that "non-rich" people are the minority, the "eroding part" of the change in price level is concentrated on the "non-rich" segment of the economy.
It is not just rich people have more ways to protect themselves against inflation.
And again, this is a utility argument. There is still the question of "why is more income better?". The simple reason is that we can buy more things and it gives us more satisfaction (aka utility). So, non-rich people, which is the majority, will lose more utility compared with rich people.
I still argue that while on an aggregate level, real income may be redistributed, the aggregate utility declines with inflation, hence showing that inflation is "bad".
If prices of essentials increases ,one would have less disposal income.Some might also have negative disposal incomes.But the urge to consume remains.Thus the money man will be ever ready to satisfy that need i.e more consumer loans etc.The economy per se will continue to grow.
ReplyDeleteAnd there will be 400 k coming into the job market ready to join the queue and continue the party.
Inflation actually has no significant impact on the country as long as circle is not disrupted i.e new mkt entrants,innovative financial schemes,low interests n salariy growth on par with inflation.
Just a minor point, salary growth is not necessarily on par with inflation, and should not be so. Wage growth, in the long run, should be on par with productivity growth.
ReplyDeleteWho needs to work hard if they can expect their pay to rise with inflation year after year?
I remember an article by Hishamh showing that salary growth is lagging productivity growth by 40% or so.I am not sure of the exact calculation but if its based on Revenues/employee..inflation will be factored within that ratio.I don't think its really possible to measure productivity by widgets/worker in the national context.
ReplyDelete