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Winstonm, on Nov 15 2007, 06:00 PM, said:
To answer any question about inflation, it is necessary to define what is meant by inflation - and there are many definitions. The Federal Reserve of Cleveland defines inflation as a rise in general prices caused by an increase in the money supply.
Under this definition, the reason U.S. inflation has not skyrocketed to match the deficit is that our inflation is exported. In the last 6 years, the Federal deficit has climbed from roughly $5 trillion to $9 trillion. If the Federal Reserve had been required to monetize that debt with U.S. currency, we would be looking at Weimer-like hyperinflation. Fortunately, we have been able to export most of that debt to China, Japan, and the OPEC nations via the trade deficit, and those countries then recycle those dollars into U.S. treasuries, thus putting a cap on interest rates via this somewhat artificially created demand.
Another reason imports are not rising outrageously is the U.S. dollar peg that many countries use for their currency - as the dollar devalues, so, too, do these currencies.
The big disaster that could cause havoc is for the dollar to be tossed aside as the world's reserve currency, thus making the holding of the dollar a liability rather than a necessity. That could cause a collapse of the value of the dollar, and a massive inflation in the U.S.
Under this definition, the reason U.S. inflation has not skyrocketed to match the deficit is that our inflation is exported. In the last 6 years, the Federal deficit has climbed from roughly $5 trillion to $9 trillion. If the Federal Reserve had been required to monetize that debt with U.S. currency, we would be looking at Weimer-like hyperinflation. Fortunately, we have been able to export most of that debt to China, Japan, and the OPEC nations via the trade deficit, and those countries then recycle those dollars into U.S. treasuries, thus putting a cap on interest rates via this somewhat artificially created demand.
Another reason imports are not rising outrageously is the U.S. dollar peg that many countries use for their currency - as the dollar devalues, so, too, do these currencies.
The big disaster that could cause havoc is for the dollar to be tossed aside as the world's reserve currency, thus making the holding of the dollar a liability rather than a necessity. That could cause a collapse of the value of the dollar, and a massive inflation in the U.S.
While I certainly beleive that the cleveland fed governors know more about economics than I do, they obviously know less about what is a definition.
In physics, we know that Force=Mass* Acceleration
in Chemistry we know that PV=nRT (for an ideal gas)
There are seperate definitions for each term here. The relationship between the abstract quantities constitutes a theory.
There is a general definition of inflation. And there is a theory about the cause. Even if everyone completely agrees with the theory, that does not mean that the theory is part of the defintion. Thats like saying that "the orbits of the planets is a motion, around the earth, caused by superimposing circular paths." -E.G The Ptolomaic model of Orbits. the defintion of orbits is destinct from the explanation. the phrase "caused by" really should never be part of a definition.
Here there really are some substantive differences between the monitarists, which obviously is the school of thought subscribed to by the Cleveland Fed, and the Kensyians, into the causes and nature of inflation, especially over the short term.
Anyway, Inflation is a notoriously difficult thing to measure, since
a. prices of different goods change at different rates
b. the mix of goods people buy change
c. the quality of the goods change over time
Anyway, as you point out in a different post, and I think Mike misunderstood, there is a big difference between a perminant change in the money supply, and a short term change.
To make a perminant change, one could
a. print more money
b. burn or distroy existing money
c. create a new currancy with is exchanged for the old currancy at a fixed convernsion rate
All of these have the effect of merely "changing the units" of money. This results in a uniform effect on all prices. (with a few technical exceptions that have to do with the fact that money is not infititely divisable, so if you say, get rid of the penny, it does effect prices, but not uniformly. 2 cent gumballs will probably cost 5 cents after the change which is a 150% increase).
the other way of changing the money supply is short term. this is the amount of money that is currently in circulation.
Imagine the following, 10Billion dollars gets put in a vault that can't be opened for 20 years, at which time someone gets it (or we all share it). the 10 Billion dollars has disappeared from the economy temporaily so no one can spend it, or lend it to someone else to spend or do anything with it for now. On the other hand, the money will be available in 20 years. As there is less money available now to purchase products, there are 2 effects here:
a. since the money available to spend has decreased, prices have to drop, since someone with $5 available will be more likely to spend $3 on a beer than someone who has $4 , assuming both of them have other things that they want or need to buy. Effectively, decreased money available results in decreased demand for goods at any given price level, and prices have to fall to reach a new equilibrium since demand has fallen. The exact effect is complicated here and may not be completely uniform across all products in the short term
b. Imagine two situations. Situation 1 is that this 10 Billion was all taken from one person and situation 2 is that it was taken uniformly from everyone.
b1. This person, who will get 10Bil in 20 years, wants to spend money now. Thus he agrees to gives someone part (or all) of the 10Bil in 20 years in exchange for some amount of money now. the conversion between these two is the effective interest rate (I will call this the discount rate). As there is now increased demand for money now then there was without this person's request, the "cost" of getting money now (the discount rate) has to increase. Thus interest rates goes up and everyone borrows less and spends less.
b2. The effect is the same if the money was taken from everyone, and is returned to everyone in 20 years. there is an increased demand for money now, and thus an increase in interest rates and a decrease in spending.
Note the 2 different effects here are linked:
prices falling (or rising slower) do to a short term decrease in the money supply, and interest rates going up.
The main way the fed controls the money supply, is by buying or selling securities. When they buy securities the money goes into the economy (and leaves "the vault") thus increasing the money supply. When they sell securities the money leaves the economy and goes into the vault. When the money goes into the vault, in general, there is less money available to spend, so inflation slows and demand for money increases causing rising interest rates.
Hopefully I have this straight now...
