The Difference Between Higher Prices and Rising Prices
OK, my post about Williamson’s QE argument left some people confused. It sounded like I was saying that price inflation causes people to want to hold more money. Huh?
The problem here is confusing higher prices with rising prices. The two are obviously quite related, but they’re not the same thing. I’ll state two principles, then illustrate with a really simple example that will make you slap your head. (Sorry.)
(1) Other things equal, higher prices (which is the same thing as a lower purchasing power of money) will make people want to hold larger cash balances.
(2) Other thing equal, a higher rate of price inflation will make people want to hold smaller cash balances.
Now the story: You are initially in equilibrium, holding $1,000 in money. (If you care, you specifically have $160 in currency in your wallet, and $840 in your checking account.) At 9am on a Monday morning, you suddenly become absolutely convinced that all prices will double by 9am Tuesday, at which point they will resume their original, gradual rise. What happens?
You drive down to the coin shop with your checkbook. You empty out your checking account by buying silver coins. You also spend the currency in your wallet, saving only a single $20 bill in case some emergency comes up during the day. You don’t want to be stuck holding dollar bills (or their equivalent in your checking account) when all prices suddenly double.
Then, on Tuesday, after everything has settled back down, you sell off your silver back for dollars. You load up your wallet and checking account again. But going forward, you end up carrying $2,000, because for all the reasons you originally held $1,000, now you need $2,000 to “do the same job.”
Back to Williamson: He notes that empirically, the massive bursts of QE–in which the central bank creates more money while sucking certain bonds out of the private sector–have gone hand in hand with lower rates of price inflation. So he is arguing that this makes sense, because in order to get the public to hold more money, you have to reduce the rate of price inflation. You can see how that’s just the inverse of Effect (2) above–and the opposite of my story about getting rid of your cash when you expect a one-shot blast of high price inflation–but clearly he is leaving something out of his explanation. (Or at least, that’s what a bunch of us are arguing.) You can see me ask Williamson this directly here.
I don’t mean this as a nitpick but isn’t it more accurate to say “an expected/anticipated higher rate of price inflation will make people want to hold smaller cash balances”?
That is, it is the expectations of people that affects their behavior, not the rate of price inflation itself.
Well Robert we’re getting into 2nd and 3rd derivatives here. Look, couldn’t I say “an expected/anticipated higher price level will make people want to hold smaller cash balances” if we’re talking about right now?
In a long-run equilibrium where, say, money stock and prices grow at 20% per year, people’s cash balances grow at 20% per year. But the percentage of their total financial assets held as cash would be smaller (forever), than in the same situation where money and prices grow only at 2% per year.
I’m not saying you’re wrong, I’m just saying it gets super complicated and you have to be precise about what the time periods are etc.
That’s a good point, I see what you’re saying.
In real purchasing power terms the price level (other things equal) has no effect on desired cash balances. But there is a direct correlation between expected inflation and real cash balances that is interesting.
If the rate of increase in the money supply increases 2 different things may happen.
1. People think there will be an increase in price inflation. They reduce real cash-holding to minimize holding an asset losing money. As they reduce their real cash balances they will spend money . The price level will adjust to this increased spending until people want to hold all the available money again.. (Note: they may end up with bigger nominal balances but the real value will be lower)
2. People think that despite the increased money supply there will be lower inflation. They might for example think that productivity growth will outstrip money supply growth. In this case they will increase real cash cash holdings and again the price level will adjust.
I think Steve Williams is imagining that QE creates effect #2.
I think Steve Williams [sic–RPM] is imagining that QE creates effect #2.
I don’t think so, Transformer. In your scenario, people for some reason unrelated to the money printing, were expecting lower price inflation. But Williamson is saying that the money printing itself is the ultimate cause of the lower price inflation. That’s why so many people are going nuts.
My interpretation of what Williamson is saying is that QE creates more safe assets which encourages more business which in turn generates more consumption. The money supply increases as a side-effect of this.
So people may be quite rationally expecting the increase in money supply to generate a slowing down in the rate of inflation (or even outright deflation) as a direct result of QE.
In addition: As long as expected return is a reason to hold money then looked at in real terms whenever the expected rate of inflation goes down (other things equal) cash holdings must go up irrespective of what is happening to the money supply.. There is no reason why an increasing money supply can’t be associated with expected deflation and lead to the effect Williamson describes.
Stated more simply:
If Williamson is saying that an increase in the money supply must be accompanied by an increased return on money he is correct as long as he means the real and not the nominal money supply.
What links the real and nominal money supply is the price level.
The only way the real money supply can increase faster than the nominal money supply is if there is deflation.
So: An increase in the real money supply will always be accompanied by an increase in the return on money. This increase will tautologically be provided by deflation.
If this is all Williamson means then he is right.
Okay so say the government makes money. The only reason that inflation is not instantaneous is because it takes time to propagate through the economy does it not? Does not the velocity of money therefore have a direct correlation to the speed at which inflation will occur due to printing money? Is that not the reason for the fact that the Fed in one way shape or form has injected over $3 Trillion in currency into the economy and we have seen pitiful amounts of inflation ( also due to the fact that prices were inflated to begin with )?
Also I think that your analogy is correct but that it would NOT take on as simplistic a form as you suggest and the repercussions would be more severe, so I would anticipate that eventually there would be another large jump at some point and not only double my ‘holdings’ buy double and then some as I would not want to be caught with my proverbial pants down again. Of course this assumes that I know ANYTHING about economics and risk of currency inflation and devaluation, which unfortunately places me in the minority of knowledge brokers. This analogy works for perhaps 10% of the people the rest are too caught up in daily life to notice and simply wonder why there is a disparage between the rich and the poor.
Yep. When you said it before, you weren’t as clear as you should have been. I had a comment asking if I agreed with (a mistaken interpretation of) what you were saying. I told them I was confident you had meant to say this:
The quantity of money demanded is a positive function of the price level and a negative function of the expected rate of change of the price level.
Nick,
Would you agree with the view I expressed in a comment above that Williamson would be right if he said “an increase in the money supply must be accompanied by an increased return on money as long as he means the real and not the nominal money supply” ?
Yes. Other things equal, of course. It could also be accompanied by an increase in real income, which is one of those other things.
Thanks.
I think this means that when (as in Williamson’s examp[e) people start to demand a higher rate of return for holding money that it will be the real money supply that does the adjusting.
Start from 0% inflation and 0% nominal money supply growth and assume something happens that means people would want a 5% return on money to hold the existing real supply (while everything else stays the same. There is nothing to induce the 5% deflation that would be needed to continue holding the existing real money supply so people will dump money and drive up the price level until the real money supply falls to match what people will want to hold at 0% return.
Interestingly though: If we had a CB that was targeting stable money velocity they would have to accommodate the 5% deflation and prove Williamson right.
Transformer wrote:
I think this means that when (as in Williamson’s examp[e) people start to demand a higher rate of return for holding money that it will be the real money supply that does the adjusting.
OK but you’re still just picking a very unusual way to restore equilibrium; it’s the same way we’re discussing it. Start in equilibrium. Then the CB injects money, and people are holding higher real balances than they want. So the price level adjusts to reduce their real balances. That means prices go up.
I don’t disagree. I was just thinking though the way that a shift in the demand for money curve (against returns on money ) would play out.
You do end up with higher returns at all levels of real money supply which is what Williamson sort of say.
But it is prices that seem to do the adjusting and I don’t think Williamson has acknowledged that.
You are at your best when at least 10 other economists disagree with one another.
Are you satisfied with his response to you? That was awful. He didn’t even beginned to understand.
Murphy, since I am likely one of those people who did not fully understand everything you said in your last post, I thought I would explain more fully where I am coming from, because I don’t think what I said prior really got through (or made total sense).
I want to focus on this statement you made:
“Other thing equal, a higher rate of price inflation will make people want to hold smaller cash balances.”
There are two ways of approaching this question. From the individual’s perspective, or from all individual’s perspectives.
From all individual perspectives:
If we consider for the sake of argument the phenomena of people trying to hold lower cash balances, then as I am sure you know, not everyone can hold lower cash balances. Every individual who lowers their cash balance requires another individual or individuals to raise their cash balance. So what happens if everyone really did try to hold lower cash balances? Since we know it won’t result in a lower quantity of money, it must have another effect. This other effect is, of course, rising prices. As people seek to reduce their cash balances, prices will rise, to a finite degree of course since nobody has an infinite cash balance. As prices rise, the desire among people to reduce their cash balances will be mitigated, until not everyone wants to reduce their cash balances anymore.
As this happens, we say that the money supply is held constant, but “velocity” is increasing. This velocity of course cannot keep rising forever on the basis of a fixed supply of money. So as velocity rises and tends towards a limit, and we assume production keeps gradually increasing “normally”, prices will then start to fall once again instead of rising as before.
As prices fall, in a context of everyone trying to reduce their cash balances and thus tending towards a maximum limit in money “velocity”, some individuals (and here is where individual perspectives matter) will start to want a higher cash to asset ratio. A lower price inflation encourages, indeed is the same thing as, ceteris paribus, a lower cash to assets ratio.
There is a tendency to stabilize if for whatever reason people change their money spending and holding habits. If things go too far one way, there are market forces that prevent it from going to infinity in that way, and indeed, the forces tend to reverse it if it goes too far one way (too far meaning too far according to individual subjective valuations).
But back to your quote. My position is that a higher price inflation, holding money supply constant, is caused by individuals seeking to hold lower cash balances. Total money supply will of course not rise, but the attempt by everyone to hold a lower cash balance will put a delimited upward pressure on prices. Prices cannot keep rising forever in this context of a fixed money supply (with the exception of falling supply, but I will assume it is gradually growing over time).
The only way I can see that quote being true, is from an individual’s perspective, who for whatever reason finds himself living in a world of a higher rate of price inflation. But in the aggregate, the causality, I think, goes the other way. People in general who want to hold a lower cash balance will cause a delimited rise in price inflation.
Of course, as the rate of price inflation increases, it cannot keep increasing forever, and as productivity catches up, prices will again start falling, which will, from the same individual perspective, encourage higher cash balances.
MF, ironically, my complaint is that you’re thinking about this mechanistically and in the aggregate, rather than subjectively from the perspective of the individual.
Suppose Bernanke announces that on January 10, 2014, he is going create a new $10,000 in money and deposit it in each American’s bank account. That is definitely going to affect the PPM right away; people won’t have to wait for the new money to actually arrive before it has effects on the PPM.
“MF, ironically, my complaint is that you’re thinking about this mechanistically and in the aggregate, rather than subjectively from the perspective of the individual.”
One has to think in the aggregate if you’re going to talk about prices, money supply, and inflation.
One can think in the aggregate in such a way so as to retain individual subjective value theory. We just have to think of every individual, separate from each other and all at once.
“Suppose Bernanke announces that on January 10, 2014, he is going create a new $10,000 in money and deposit it in each American’s bank account. That is definitely going to affect the PPM right away; people won’t have to wait for the new money to actually arrive before it has effects on the PPM.”
I agree with that. But that isn’t how money finds it way into people’s bank accounts in our monetary system. Your bank balance goes up through exchanges. Every individual’s bank balance goes up through exchanges. But if every individual’s bank account goes up through exchanges, it means that their existing labor or production will have to bring in more money than before. In other words, prices rise as a consequence of a rise in the money supply.
I don’t see how I am thinking in mechanistic terms, because the fact that prices rise on the basis of more money is grounded on subjective value theory.
You can’t consider an individual in total isolation of all other individuals. If you’re going to include money in and money out from the individual’s perspective, you’re necessarily including other individuals.
MF I have to be brief, but in a previous post I thought you said something to me like, “If we hold output constant, then a fall in the purchasing power of money IS THE SAME THING as a rise in the quantity of money.” Or something like that. So my thought experiment shows that this isn’t true. Output and quantity of money can stay the same, just subjective expectations can change, and that will change the PPM.
Huh? Didn’t your thought experiment posit a rise in everyone’s cash balance, i.e. a rise in the quantity of money? How is that mutually incompatible with the argument that a fall in purchasing power of money IS a rise in the quantity of money (holding supply constant)?
Because MF, in my thought experiment the quantity of money doesn’t increase until January 2014, but the PPM falls right now.
OK sure, I also mentioned that this is possible, but that the fall in the PPM is delimited. It cannot keep going down.
Sure it can, in the crack-up boom. People can abandon a currency and its PPM goes to zero.
Doesn’t a crack up boom require significant increases in the quantity of money though?
MF depends what you mean by “require.” If Bernanke said “Next month I am going to issue $100 trillion in new currency and give it to people randomly” then it’s possible the dollar would utterly collapse before he even printed $1 more.
Now maybe in practice people would want to see him carry out his threat before dropping the dollar, but in principle the dollar could collapse even with no additional printing.
OK, thanks, makes sense.
But wouldn’t people be forced to still use dollars due to being taxed in dollars?
I can see how people would want to “fly into real values”, but I don’t see an outright rejection of the dollar happening. Only if the dollar were not forced as tax and legal tender would I see a rejection being possible. Or else revolution and civil war…
Perhaps though, people will start barter trading for the goods they want, or they will seek to offer their goods and services for precious metals or something else that retains value, and “remonetize” those things.
But…
Suppose that the threat didn’t pan out. Bernanke lied.
The dollar might spring back to life as people no longer sought to dump all their dollars.
So the “crack up boom” would last for only one month.
But if Bernanke didn’t lie, and the crack boom took place, and the dollar stayed collapsed, then we would be observing the necessity of actual inflation on a (permanent) crack up boom, wouldn’t we?
MF you sound like Hut Tax Lerner!! (Roddis phrase)
I don’t believe money arises from the state.
But I do believe that the state can, over time and through stages, monopolize the medium of exchange. Once that occurs, the only thing holding it together is successful taxation.
This is not Hut Tax Lerner, but I get the joke.
> because in order to get the public to hold more money, you have to reduce the rate of price inflation
I think this is wrong, at least in the macro. To get people to “hold” more money, the CB just needs to buy something and not sell it back. The money injected into the economy may flow around (if the holders anticipate a high rate of inflation, etc), but it will be “held by the public” while it flows.
The flow stops when prices rise *and* people anticipate low future inflation. Otherwise, it will continue flowing.
At 9am on a Monday morning, you watch a Peter Schiff video and suddenly become absolutely convinced that all prices will double by 9am Tuesday, at which point they will resume their original, gradual rise. What happens?
You drive down to the coin shop with your checkbook. You empty out your checking account by buying silver coins. The price of coins promptly falls, the inflation doesn’t happen, and you later sell your coins for a lower price.
I think the idea of ‘hold’ is ‘remove from circulation’. If you want people to keep more water in jerry cans you need to slow the rate the rivier is rising.
That may not be a useful idea, water is water, but I think that is the idea.
Nick Rowe, can you clarify what Bob meant?
I think the idea of ‘hold’ is ‘remove from circulation’….Nick Rowe, can you clarify what Bob meant?
If you’re done being fascinated by your own wit, Ken, permit me to explain that no, every bit of money is being “held” by someone. There’s no such thing as “money in circulation,” which is not being held by someone. At any moment you like, every unit of money is in someone’s cash balance.
When the central bank issues more money, yes people will take it; just imagine the bank literally handing out $100 bills. But then the issue is, the market for money (not the same as “the money market”) is no longer in equilibrium. The quantity of money in existence is higher than the quantity demanded. So what restores equilibrium (at least in the normal story) is that prices rise.
Switch it to apples. If there’s a bigger crop than expected, farmers end up holding more apples than they intended. So the normal reaction is for them to lower the unit price.
“There’s no such thing as “money in circulation,” which is not being held by someone. At any moment you like, every unit of money is in someone’s cash balance.”
What do the cash hoarding doomsayers want? Yes, they know that at any given time, every dollar is being held. What’s really going on is that they want to retain for themselves, whatever their desire happens to be that day, the intellectual authority (and hopefully political authority) to determine just how long of a time can pass that a person can hold their money, before they are to be “punished” by inflation.
Is it one minute? No, even they would say that is too short. Don’t accuse them of wanting people to spend their money one minute after they earned it! That’s just a straw man you see. And don’t say one hour either! And don’t say 2 hours! Or 3 hours!
Don’t ask them to actually tell you a time frame. They don’t want to give away too much, because they are relying on you staying oblivious to their ultimate goal, which is of course control over you.
They’ll scream from the hilltops when cash holding times become “obviously too long”, as for example whatever is associated with a “depression”.
They believe, a priori, that others individuals besides themselves cannot be trusted to use their own money “wisely”. For if the individual has full control over his own money, then the individual has the capability of DENYING that money to others, who WANT money even if they have nothing valuable to offer those with money. That’s why they want a coercive central bank. To essentially punish anyone who dares withholding money that rightfully belongs to “society”.
Or are you an unemployment lover? Hmm?
“So he is arguing that this makes sense, because in order to get the public to hold more money, you have to reduce the rate of price inflation. ”
Marris pointed out the macro contstraint. “To get people to “hold” more money, the CB just needs to buy something and not sell it back. The money injected into the economy may flow around (if the holders anticipate a high rate of inflation, etc), but it will be “held by the public” while it flows.”
Marris is right I think, which is why the claim is — as I noted maybe not useful — but (unlike some here) before I dismiss a claim I like to understand it. So I replied to marris trying to find a way to make sense of it. A cash reserve I hold in my pocket and don’t spend is ‘out of circulation’ like water stored in a jerry can rather than flowing from a tap into my stomach.
So if you’re done being fascinated by your own refusal to ever try to understand the words of those you dislike, can you (or Nick Rowe) explain any other way in which marris’s point not a killer?
Anyway to read the disputed claim that does work?
OK Ken B., I should not have escalated the hostility, since this really is a matter of just knowing the way economists talk about things. (I’m not saying that to sound patronizing, I’m being serious, it’s like if physicists said a guy holding a 20 pound weight at arms-length wasn’t doing any “work” and an outsider would flip out.)
When we say “to get the public to hold more money” we mean *in equilibrium*. So yes, if Bernanke starts throwing out $100 from a helicopter, it’s not going to take any prodding to get people to pick them up. But the market for dollar bills would not be in equilibrium at that point (assuming it had been before), if people hadn’t been expecting the injection of new money. People would be holding more money than they wanted. They would try to spend it on stuff. The normal way to get the community to hold the higher cash balances *and be content with them* is if prices rose.
It can be useful to debate whether thinking of people wanting to “hold” money is as useful a way of thinking compared to talking about a desired velocity of circulation. Just like a car dealer, who wants to hold an inventory of cars, and also has a desired velocity of circulation.
But that is the way economists normally talk about the desired average inventory of money.
That “normally” talk assumes money provides utility the way cars provide utility. But money is a medium of exchange. People don’t have a desire to consume money as an alternative vis a vis other goods that are also subject to scarcity. They have a desire for money to acquire goods.
I don’t see how people have a desire for velocity or circulation “the same way” as car sellers.
Most people desire cars because cars provide utility. Except car dealers, who desire to hold an inventory of cars only so they can buy and sell them.
Everybody desires to hold an inventory of money so they can buy and sell it.
Car dealers – cars
Everybody – money
That’s funny Bob I thought you were ramping down the hostility there.
🙂
“So yes, if Bernanke starts throwing out $100 from a helicopter, it’s not going to take any prodding to get people to pick them up. But the market for dollar bills would not be in equilibrium at that point (assuming it had been before), if people hadn’t been expecting the injection of new money. People would be holding more money than they wanted. They would try to spend it on stuff. The normal way to get the community to hold the higher cash balances *and be content with them* is if prices rose.”
Murphy, again I think I have to emphasize a point that I think continues to be shoved to the side.
I am not saying you disagree with this, but I will say it anyway: People do not have their own desired cash holding times based on the supply of money they have, or the change in money balance they experience. It’s not like if you were flushed with $10,000 cash tomorrow, that you would think “I have too much money on me, I have to spend it to get me down to a balance I want.” What people take into account is their cash balances relative to the prices of their assets, and prevailing prices for the goods they buy. It is prices that guide people into thinking they have too much or too little money.
If everyone’s money balances doubled, but every price doubled as well (and everyone knew prices doubled), then nobody would think “I have too much money on me, I should get rid of some.”
Again, I am not saying you disagree with any of this, or that you said something inconsistent with this. I think it just has to be emphasized.