Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday, 2 September 2014

Simplistic theories of inflation

After I wrote this I saw that Frances Coppola has a post that covers some of the same ground, but the point I want to make is different.

One of the things that made monetarism so popular until governments actually tried it was its simplicity. You can express this simplicity in many ways, but most involve the idea that there is a stable demand for the real value of money (M/p), so if you can control M you must control p. Never mind that the immediate influences on inflation were much more complicated: if you knew what M was, you would know what p would be. If you controlled M you would eventually control p.

There are lots of problems with this idea. I talked about the difficulty in explaining prices by just using money in this post. The difficulty of finding the ‘right’ definition of money is not a technical problem but a feature: because money can be saved as well as buy goods (the medium of exchange is also a store of value) focusing on its role in buying goods (‘hot potatoes’) is misleading. But even if there was a stable long run demand for money for some definition, the usefulness of this becomes questionable if we cannot say what the future quantity of money will be.

This becomes blindingly obvious if money is base money and we think about Quantitative Easing. Printing base money under quantitative easing does not imply hyperinflation because the expansion in the monetary base will be reversed once the recession is over. Knowing what base money is becomes useless as a tool for saying what future prices will be. (For those more technically minded who still think there is a Pigou effect, I discussed why the Pigou effect has disappeared from modern macro here. It is based on the same point.)

The Fiscal Theory of the Price Level is potentially another simplistic theory of inflation. This works from the identity that the real value of government debt must equal the discounted value of primary surpluses (taxes less government spending). It also can be used in a naive way: treat future primary surpluses as fixed, and any increase in nominal government debt must lead to higher prices. But, as Chris Sims explains in this nice exposition at Lindau, future primary surpluses are not fixed. If debt increases, future primary surpluses can increase to pay the interest on that additional debt, and more.

There may be some that say that we cannot trust politicians to do that. To which I say which planet have you been on for the last five years? As Brad DeLong reminds us for the US, this recession has been unusual in the zeal that governments have shown in rapidly reducing primary deficits, and of course in the Eurozone this zeal - embodied in the fiscal compact - has led to a second recession. Chris Sims raised the possibility that so great has this zeal been that even though nominal debt has risen, the price level might fall to make the identity hold.

One lesson I would draw from this is that the Fiscal Theory of the Price Level, like monetarism, is not a terribly helpful way of thinking about future inflation. The idea that we can take one variable, or one equation, and distil from that the future price level is a fantasy. What is surprising is that this fantasy has been, and still remains, so attractive for some economists.


  1. Fascinating. Just completing a paper on this very topic (from heterodox viewpoint). Again all fails on not establishing initial value for financial assets - just assumed or modelled ad hoc.

  2. Sims has a v suspicious opening argument: that paying interest on reserves somehow miraculously changes the way we model macroeconomies. Modelers want money to be a liability because it simplifies modelling. Sims can then reduce inflation to a single fiscal sustainability equation. Ironically, the effect - as here - is to over-complicate. Base money is not a liability. Therefore in one sense the Pigou effect is completely valid. As Buiter correctly argues, helicopter drops are an increase in wealth - and would obviously work. Sims and Woodford seem to have lost sight of the obvious.

    1. The Pigou effect is about how with fixed M, falling p makes people richer. But even if money is not a liability, it is its future value that is net wealth, as Buiter makes clear. So Pigou effect does not work as a wealth effect - future M/p does not change.

    2. Simon, the "Pigou" label is a distraction. I am merely pointing out that where M is base money, and no one's liability, an increase in M given constant or falling P is a rise in real wealth. This is extremely relevant to the obvious efficacy of a helicopter drop (transfers to households financed with base money). Critically, QE does not refute a v simple monetarism - where helicopter drops raise demand. It actually matters whether the increase in M is a cash transfer to a household (increase in private sector wealth) or the replacement of a govt bond with a cash balance (no change in private sector wealth ... Although possibly a reduction in govt net debt - that's another story!).

  3. Simon,

    I think this part is the key: "Printing base money under quantitative easing does not imply hyperinflation because the expansion in the monetary base will be reversed once the recession is over."

    Most monetarists would agree with that and point to it for the why QE has not been very effective. It is why I have called for QE or helicopter drops to be tied to a NGDP level target. The level part is key and implies a commitment to a permanent increase in the monetary base if needed.

    1. The obvious reason why QE has not worked is that it has not altered the private sector's net wealth. It has merely altered its liquidity. Helicopter drops would alter private sector net assets - and the liquidity of cash-strapped households. The issue of permanence/impermanence is exaggerated. It implies binary and confident expectations. We form a probabilistic expectation of the likely duration of QE. But there is far too much uncertainty over: eq real interest rates (I think they are negative), demand for reserves (logically they should rise after a financial crisis), trend growth (who knows) inflation measurement uncertainty given innovation (probably much lower than measured). An "expectation" about the duration of QE given this level of uncertainty is unlikely to be the basis for decision-making. One caveat: Bernanke's attempt (in the Washington Post) to boost stock prices by committing to announce additional stimulus if they fall was an astute attempt to manipulate real wealth. But this was an explicit attempt to exploit model uncertainty to change the risk properties of a privately-sector asset and to reduce the equity cost of capital of firms.

    2. Printing base money under quantitative easing does not imply hyperinflation, or even an increase in inflation, because to increase inflation you have to increase aggregate demand to close the output gap. This is the case in today's Eurozone situation, where the output gap is huge. QE will not raise inflation in the Eurozone. Currently, it takes a big increase in deficit spending to achieve an increase in inflation.

    3. Eric Lonergan,

      I may be teaching grandmothers to suck eggs, but MMTers will agree with your first sentence. That is, MMTers claim that the sum of base money and national debt (which they refer to as “private sector net financial assets”) is more important than how much of PSNFA consists of base money vis a vis debt. The only exception to that comes where the state borrows back almost all the base money it has issued, which leaves commercial banks short of enough base money to settle up with each other.

    4. @Marco Cattaneo2 September 2014 10:31

      How big an increase in deficit spending would it take to achieve 3 % inflation in Germany (SWL's favourite recipe for saving the Euro zone)?

  4. " It [Fiscal Theory]also can be used in a naive way: treat future primary surpluses as fixed, and any increase in nominal government debt must lead to higher prices".

    Isn't this theory just as dependent upon an assumption of fixed velocity of money as old monetarism ? If the deficit increases but is matched by a fall in velocity then we won't necessarily get inflation.

  5. There is no reason for a government to run a budget surplus unless it is liquidating its own assets. If you are an oil exporting nation, for instance, you are liquidating your assets. At some point in the future, the party will come to an end when that resource is finished. When you sober up, you will have to ask yourself the question, "f**k, what do we do now to make a living".

    A sovereign fiat currency economy, that has a balance of payments deficit like the UK, making a budget surplus, is a nonsense; by definition. If you are importing more than you are exporting, either the private sector or the public sector has to run a deficit with the "rest of the world" to pay for it.

    When things look like crap, the private sector stops spending and starts saving, be it a household or a business. If the private sector still wants to max out the credit card to buy those imports; AND, wants to save a bit from its wages as well, the only answer is the government sector has to run a budget deficit to pay for both.

    Remember, the government's budget deficit is the private sectors savings, pound for pound. The government, including its wholly owned central bank, will eventually get its net spending (what we call the "national debt") back via taxes. BUT and it is a big BUT, WE THE PEOPLE, have decided that we are going to hold on to it for a while. That is, we are going to SAVE it, because we don't trust the government, or its central bank, to look after OUR interests, ("we" being 99% little people of the UK). ;-) . ATB Acorn.

  6. Simon,

    Have you seen my two variable model of the price level P = P(NGDP, M0) where M0 is the currency component of the monetary base?

    Here's an example result for trend inflation in the US over the past 50 years or so (graph at link):

    It's quite a different approach: modelling an economy as a communication system mediated by money. It doesn't explain the fluctuations but does a pretty decent job of getting inflation right -- at least for the 10 economies I've looked at so far, including the EU and Japan.

    It also reduces to the ISLM model during low inflation and something like the quantity theory of money during high inflation. The basic communication concept also leads to supply and demand diagrams. I swear it's not the ravings of a madman :)

  7. You say, "Printing base money under quantitative easing does not imply hyperinflation because the expansion in the monetary base will be reversed once the recession is over."

    Here is where you are wrong. They will not reverse the injection of money. They will keep making more money.

    I have a theory of hyperinflation. Can you take a look at it?

    1. Vincent,

      Both Japan and the EU reduced the size of their monetary base -- I put some links in a comment below. In the graph for Japan you can see neither the increase nor the decrease had an effect on the price level.

      In Japan, the monetary base is a terrible model of the price level:

    2. Excess reserves are not counted in M1 or M2 and I don't claim or expect they contribute to normal inflation. I do think they act like government debt when it comes to hyperinflation. The more excess reserves and government debt above around 80% of GNP, the higher the risk of a positive feedback loop called hyperinflation.

    3. I was aware that Japan reduced their MB but did not realize the EU did so also. Interesting graph. Thanks. Still, even if a few countries have significantly reduced their MB, the normal case is for the central bank to keep expanding their balance sheet, so I don't think you should expect it.

  8. " Printing base money under quantitative easing does not imply hyperinflation because the expansion in the monetary base will be reversed once the recession is over."

    How? And how often do politicians do that?

    1. Anonymous3 September 2014 04:04

      I retract the second question since you have already answered it for the last 5 years.

      But I repeat the first:


    2. Presumably the BofE just starts offering its stock of bonds on the open market - although this would not be without consequences for that market.

    3. More importantly, why would they bother?

      What does it mean when, if you consolidate the national accounts, 30-40% of government bonds are owned by ... the government?

      Going further, what does "the national debt" and "the deficit" mean if that is the case?

    4. Both Japan and the EU reduced the size of their monetary base.

      You can see Japan doing it here in 2006:

      Here's the EU doing it over the past 6 years:

      In the graph for Japan you can see that neither the increase nor the decrease had an effect on the price level.

  9. Here is a simplistic theory of inflation, or at least a nice correlation related to inflation which is not mentioned that often (and perhaps little known):

    Heiner Flassbeck and Friederike Spiecker, the main authors at, have for some time been looking at a strong correlation between the development of unit labour costs and the GDP deflator.

    This is a glimpse of what that correlation can look like in the long run: This figure is taken from

    In the short run the correlation is weaker as can be seen by the example of France or Japan but the effect is still visible. Other countries look the same.

    I believe the causality to be wages causing inflation, not the other way round. I would be interested to hear what you think.

    If this causality holds Mario Draghi tomorrow should be advised to talk about wage policy in Europe. After all he wants to avoid deflation.

    1. I believe wages are just another price that goes up with inflation -- so this doesn't really have any explanatory power. It's like saying the price increase of one class of items is correlated with the price increase of all items. Everything that is sold is the income for somebody, so if the aggregate price of goods goes up, then aggregate wages also go up.

      Another way to look at it is that GDP-I should equal GDP-E without inflation.

    2. Now this is interesting to think about. We have two competing attempts to explain things.

      One says something like: Inflation is a complex phenomenon, and we believe it to be driven by many factors. Identifying these and coming up with a consistent explanation is a challenging tasks. At the same time wages are endogenous. They are somehow determined on thousands of labour markets, and this is a complex process as well. Also it may be that wages and inflation are correlated, but that does not prove one to be causal for the other.

      The other model believes the average hourly wage to be a much more exogenous variable. Its growth rate can be influenced by government intervention. The German government has just done this during the last 15 years, in order to improve German competitiveness relative to other European countries. Heavily falling wages in Southern Europe recently also show that this kind of intervention is possible. Note that governments are also employers. Even more, they can set a minimum wage. If a government decides to drive up the wages it pays and also the minimum wage by, say, 3 percent each year, I expect this to have quite an effect on wage dynamics in industry jobs etc. Inflation rates (minus productivity gains) will follow this wage setting.

      This second model sounds much more plausible to me. The 1970s in some years had wage increases of 10 percent in Germany, and duly inflation shot up. And today we are experiencing the reverse process in Europe: Falling wages or at least subdued wage dynamics due to government intervention drive us into deflation.

      But - ironically speaking - we must keep to what economists were taught in our universities for 30 years: Wages are determined on a market, and government intervention in markets is evil. Therefore wage policy (unless it drives wages down) is a term not to be mentioned and not an official policy tool.

      We rather let Europe run into a spiral of deflation and depression than reconsider our belief that a sensible wage policy might be good for our economies.

    3. I'm not saying government policies can or cannot influence wages or what policy is optimal. And I don't think anyone is denying that if you raise the minimum wage at some regular rate, the wages that are paid will go up (there are debates about whether aggregate wages go up in that case -- I personally think they probably will).

      But all of that is beside the point.

      We are talking about a model of inflation in terms of wages. To leading order, the value of all goods and services produced are the incomes of everyone producing them. Goods and services bought must equal goods and services sold. Therefore a relationship between wages and inflation is trivial.

      If I sell 40 € of apples, my income is 40 €. If inflation is 10% per year, the next year if I sell the same number of apples, I sell 44 € and my income is 44 €. Apples bought must equal apples sold, so price inflation is wage inflation.

  10. °...which planet have you been on for the last five years?"

    France, perhaps?

  11. Simon, Who exactly ARE THESE economists who are out and out monetarists? All I can think of are Market Monetarists. If it's the latter you have in mind, then I quite agree with you.


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