No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Twelve: Money Mischief 283 The Fed is chartered to broadly do two things: (1) keep maximum employment consistent with (2) price stability. These two objectives— low unemployment and low inflation—are seemingly in conflict, at least in the short run. There are always political pressures for easy money to stimulate the economy (especially before elections) and reduce unemployment. The problem is that after that stimulation, prices will ultimately rise. Historically, Milton Friedman has shown that it takes about 6-18 months for monetary policy to have full effect. Nevertheless, the consensus among economists is that the best way to provide maximum employment over the long term is to provide a stable monetary environment with low inflation. To help us think about inflation, imagine you go into Wendy’s, and the junior bacon cheeseburger has gone up from 99 cents to $1.19—a 20% increase. Is this a result of inflation? Well, maybe, maybe not. Prices rise all the time; prices also fall a lot of the time. Some go up, others go down as the market (through the pricing system) indicates the relative scarcity of given goods. These relative prices (the prices of each good relative to others) are powerful signals to consumers and producers to either consume or produce more or less. If prices on average are generally rising, most people think we have inflation. Inflation can be formally defined as “a rise in the general level of prices over time.” In practice, financial papers and public officials use the consumer price index (which measures a basket of commonly used consumer goods) to measure inflation in the U.S. As we’ll see, this view of inflation is insufficient and misleading, and causes great monetary mischief. But it is the way you will see inflation defined in most places. In earlier eras, inflation was more properly thought of as an increase in the money supply. Changes in some price level were not needed to consider a policy inflationary, although price increases would eventually follow an increase in money supply. The earlier definition has advantages of potentially identifying monetary problems before they can get too big, but is a bit more opaque in modern economies that don’t have a 100% reserve gold standard. If the monetary base is expanding but M2 is not, do we have inflation? What about if the monetary base is decreasing but M2 is increasing? Since the financial crisis and the Fed’s implementation of unprecedented easy policy we see the former situation, as the monetary base has expanded greatly while the broader aggregates have increased at a much lower rate. So in the spirit of our 2nd best fallen world, let’s use the common definition of inflation. However, we will not use the common method of measuring inflation, as that is the source of most of our problems. Consumer prices are just one type of price in our economy. Recall in chapter 7, that we introduced the structure of production, where goods of the 1st order were consumer goods, and goods of higher orders were earlier producers’ goods. For example, a loaf of bread might be the 1st order good, with flour being a good of the 2nd order, wheat being a good of the 3rd order, and seeds being a The consensus among economists is that the best way to provide maximum employment over the long term is to provide a stable monetary environment with low inflation.